investment risk

Risky Business

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We love working with you, the best clients in the world, because you’ve accomplished what some find impossible. You have recognized that long-term investors get paid to endure volatility. Some of you came to us this way. Others have learned across our many interactions. A few of you are still learning. 

Up to this point, we have mostly defined risk by what it isn’t, as in “volatility is not the same as risk.” It might be useful to be more explicit about what types of risk we do consider. 

Recall that our risk assessment takes place with a long time horizon in mind. We believe that you should have the money you’ll require for the next 3–5 years invested outside of the market. (Short-term volatility is a risk during the short term.) 

If you’re parking your money with us for a longer time horizon (3+ years), here are some risks we do factor into our strategy:  

  • Inflation risk. Over time, what’s the likelihood this investment will outpace inflation? Put another way, what’s the risk of losing purchasing power over time? 
  • Investment risk. Over time, what’s the likelihood this investment will substantially change for the worse or the players will go out of business? 
  • Concentration risk. Too many eggs in one basket could spell trouble if the basket upsets. 

How much risk a portfolio might endure depends a number of factors—your investing time horizon being just about the biggest one. And of course, there are other types of risk in the mix, but the topic is important enough to offer you more information from time to time. 

Clients, if you want to talk about your risk exposure, email or call. 

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Where Did All The Risks Go?

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In what seems like the good old days, we thought about many kinds of risk. Now, to many, risk only means one thing. All the other kinds of risk seem to have disappeared. Here are some of the classic risks as we learned them long ago, and still understand today:

Market Risk. Changes in equity prices or interest rates or currency exchange rates that hurt the investment value.

Liquidity Risk. Being unable to sell an investment without a discount for lack of buyers.

Concentration Risk. Having all your eggs in one basket, when the basket gets upset.

Credit Risk. A bond issuer might not be able to pay you back because of adverse conditions.

Inflation Risk. A loss of purchasing power over time because investments fail to keep up with a rising cost of living.

This old-fashioned approach to risk focused on possibilities for what might happen in the future. This makes sense to us, since the future is where we will get all of our coming investment results, good and bad. The past is past.

But perhaps the most popular approach to risk today is based totally on the past, not the future. Past volatility is supposedly the measure of risk in any investment and every portfolio. Modern Portfolio Theory (MPT) implicitly assumes that past volatility is the sole measure of risk. Yet volatility is inherent in any form of long-term investing, and has little to do with many of the classic forms of risk.

Investment firms and advisors promoting ‘risk analytics’ and many measures of ‘risk tolerance’ are using this backward-looking theory of risk. It has nothing to do with the classic definitions of risk, outlined above. In our opinion, some of the latest and greatest risk management technology is not focused on actual risk at all, and could discourage people from enduring the volatility required to achieve long term results.

Meanwhile, the classic understanding of risk has us thinking about its many dimensions as we choose securities and build portfolios. One drawback of our approach? It takes more work to do things the old-fashioned way. But we think it is the right way to go. No guarantees, of course.

Clients, if you would like to talk about this or anything else, please email us or call.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.