In terms of your investments, risk can be defined as any uncertainty that has the potential to negatively affect your financial welfare. Risk offers the possibility of complete loss of capital. It is my contention that the majority of investors consistently misunderstand the concept of risk when making investment decisions. Many investors mistakenly view risk as market volatility - the day-to-day or year-to-year swings in asset prices. However, long-term investors should care more about the risk of losing purchasing power over time due to inflation or a permanent loss of capital. Volatility is the chance of sudden and unpredictable movement. Volatility can actually be an opportunity for an investor to buy more shares at a lower price during a downturn. Some fairly recent examples of negative volatility would be: 1.) Dot.com bubble of 2000 when the stock market dropped 40% over 3 years; 2.) Great Financial Crisis (2008-2009) when the market dropped 37% in one year; 3.) Black Monday (10/19/87) when the market dropped 21% in one day; 4.) Covid-19 fast and furious recession (2020) when the market dropped 30% in 3 months. Shrewd investors were able to take advantage of these market swoons and profited greatly when the stock market recovered and resumed its right and upward trek.
Not properly understanding the underlying risk of an investment can lead to some unfortunate outcomes. In addition, allowing human emotions to determine asset allocation is a recipe for disaster. Many investors, whether due to social influence or the fear of missing out (FOMO), will buy or sell assets based on what others are doing. This "herd" mentality often leads people to participate in market bubbles and sell during crashes. We have all heard the adage, "buy low and sell high," but the reality is that many investors do just the opposite. If you buy a stock when the market is hot and prices are high, you will have greater losses if the price drops for any reason compared with an investor who bought at a lower price. There are a couple of human nature biases that can nudge investors into potential risk traps. One is referred to as recency bias - the tendency to assume that recent trends will continue indefinitely. The other bias is known as loss aversion bias. The pain of losing money is psychologically more powerful (by a power of two) than the pleasure of gaining it. Aversion bias can cause investors to make irrational decisions, such as holding on to a losing investment too long or selling a winning investment too soon.
The fundamental error that many investors make with their risk assessment process is that they limit it to determining a binary outcome and do not include the element of probability in the equation. Risk is reduced to either yes/no, win/lose, 0/1, good/bad. In other words, all-or-nothing thinking void of nuance and without a middle ground. Instead of avoiding risk, an investor, or his advisor, should strive to manage risk. Smart risk-taking involves making investments where the potential upside far outweighs the possible downside. There is nothing wrong with risking modest amounts of capital for the chance of significant gains, without betting the farm. Think of it as risk with a safety net.
Investors who hold too much of their portfolio in cash or ultra-conservative investments are vulnerable to a guaranteed, long-term loss of purchasing power due to inflation. This will especially be the case if inflation creeps higher over the next decade. The argument can be made that the government intends to run the economy hot with higher inflation and financial repression being utilized to mitigate the federal debt level problem. Investors should thus avoid long-term bonds like the plague. The rate of return on Bank CDs and U.S Treasury securities will end up less than the rate of inflation. In other words, the poor saps who invest in fixed-income instruments will lose significant purchasing power over time.
In general, higher risk is associated with the potential for higher returns, and lower risk with lower returns. However, higher risk does not always translate to higher returns. The returns for certain investments are high for a reason. It is important for the investor to spend some time and energy on a risk/reward analysis. But before identifying specific investments, an investor needs to determine the amount of his assets, outside of blue-chip equities and stock indexes, he is willing to put "at risk." Following are suggested risk allocation levels for different investor profiles: 1.) Conservative - 1% to 5%; 2.) Balanced - 5% to 10%, 3.) Aggressive - 10% to 20%. Real-world examples of some alternative investments with inherent risk would be precious metals, stock options, speculative stocks, and cryptocurrencies, in particular, Bitcoin. It should be noted there is one overriding rule when pursuing assets of this nature: Never risk more than you're willing to completely lose.
Selecting assets perceived to be riskier than normal but resulting in outsized returns is both a challenging art and requires some brain work. On a personal basis, I remain a work in progress, ever-striving for a higher lifetime batting average. This may not be an apt analogy, but in many respects, the decision-making process is similar to the bets made by a professional blackjack player who has the skills necessary to hold a slight edge on the house. Like the blackjack player, an investor can take small, calculated risks when the math works in his favor. If successful, this can drive portfolio growth without threatening financial security. In theory, losses are capped and gains are uncapped. By allocating only a small percentage of capital to higher-risk opportunities, even multiple losses won't significantly impact overall wealth. The key is to suffer modest losses on some risky bets, but more than make up for the losses by capitalizing on a few big wins when the probability of success is favorable. An investor's risk allocation percentage is dynamic over a lifetime and never static. As wealth grows, the dollar amounts grow but the percentage allocated to risk assets should align with risk comfort and life stage.
As I wrap things up and tie a bow to this blog, I would be remiss if I didn't mention a few other ways to mitigate investment risk. My basic premise thus far is that there is more risk being overly conservative instead of accepting and managing selective risk when conditions justify such and opportunities present themselves. In that light, investors should not lose sight of sticking to the basic principles of broad asset allocation and diversification. A common mistake is when investors over commit to one asset class or individual security and fail to rebalance when there is exceptional appreciation. There is nothing wrong with realizing some gains when a holding far exceeds expectations and is disproportionately represented in your portfolio. Trimming back to the original allocation percentage makes sense in such a situation. Also, although there is some added cost to your investment, there are times hedging provides protection to downside risk. It would also be wise in general to avoid leverage to fund investments. Lastly, instead of fearing risk, embrace smart and timely risk and manage it closely.
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