Do you know anyone who dumped too much money into a speculative stock at the peak? Or someone who panic sold investments during the 2008 or COVID crash?
These actions are symptoms of excessive risk-taking that can ruin your ability to grow wealth.
This is why it pays to understand risk and your unique risk tolerance. It will set you up to build sustainable wealth.
My aim is to have you walk away from this post with a firm grasp of investment risk.
What is Investment Risk?
Risk is the potential for loss.
It is often defined as the short-term volatility of an investment, the intensity of the ups and downs of an investment’s price. We will stick with this definition for now.
Another way to look at this is that risk is a measure of how “choppy” the investment is over time. The price of a risky investment will swing more wildly, and be more “choppy” than the price of a low-risk investment.
This graph compares the price of two investments from Sept 2019 to Dec 2021. This period includes the COVID crash.
The blue line shows the % change in a stock fund since September 2019, and the purple line represents % change a bond fund since September 2019.
This graph teaches us a few good lessons about volatility:
- The bond fund is stable with low volatility and low risk. It stays within a +/- 6% of it’s Sept 2019 value.
- The stock fund (small cap value) is very volatile. It drops by -44% from it’s Sept 2019 value during the COVID crash. Then it reaches +67% from its initial value in September 2021.
- Higher risk comes with higher long-run returns and more emotional turmoil.
Where Does Investment Risk Come From?
Volatility is a measure of risk. Great. But where does investment risk actually come from?
Investment risk comes from uncertainty in expected future cash flows. Let’s understand this by looking at the risk of a stock.
A stock represents ownership of a piece of a company. The price of that stock is based on the future cash flow that you expect the company to produce. This cash flow comes in the form of a dividend payment or sharebuybacks.
The stock price goes down when the expectations of future dividends change. Price goes up when future dividends become more certain (less risky), and prices go down when future dividends become less certain (riskier).
Now for the next logical question: What factors influence the certainty of future cashflows?
Some risk factors that may alter future dividends (cash flow) of a company include:
- Bad management
- Legal problems
- Natural disasters where the company operates
- Changes to Regulations
- Changes in Interest Rates
Risk that applies to all companies is called Systematic risk. Systematic risk applies to the entire “system”. In the case of stocks, the system is the global stock market, which is in turn dependent upon the global economic system.
Examples of systematic risks include large-scale war, climate risk, interest rate changes, inflation, global pandemics, and global recessions.
These risks impact all stocks. Therefore, you can’t avoid systematic risk. It cannot be diversified away, and you are compensated to take this risk in the form of higher returns.
A risk that you get paid for is called a “priced risk”. Systematic risk is therefore a priced risk. You can learn more about systematic risk here.
The Stock Market: A Complex System
The stock market is a chaotic complex system. Such systems are subject to unpredictable Black Swan events.
These events can leave you with short-term losses ranging from 30% to 50% (with a 100% stock portfolio). Such temporary loss can occur even when you reduce risk as much as possible through diversification.
Non-systematic risk, also called idiosyncratic risk, is the risk associated with individual companies or singular industries.
By placing “all your eggs in one basket”, say by owning one stock, you are exposed to the risk of a single company. Examples include
- Incompetent management
- An at-risk supply chain input
- An oil company that has a large oil spill
- An airline that has a faulty fleet of aircraft
- Changes to regulations that impact one industry
This type of risk can easily be diversified away by owning multiple businesses (stocks). Why would the market compensate you for taking on risk that can so easily be avoided?
It doesn’t. The market does not reward you for taking on this type of risk.
The next logical question is how to minimize non-systematic risk? Easy. Invest in a large basket of stocks across different industries, sectors, and geographies. This is called diversification.
The total risk of your portfolio is the systematic risk + the non-systematic risk. The non-systematic risk declines as you own more stocks across a variety of industries and geographies. Systematic risk remains unchanged no matter how many stocks you own.
This pretty graph outlines how this works.
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Risk and Diversification
What is Diversification?
Individual businesses can fail. Market sectors can perform poorly. Sometimes, entire industries or countries never recover. The Japanese stock market is a good example; it still has yet to recover from its peak in 1989.
This (non-systematic) risk can be avoided by holding various stocks across different industries and countries.
Further, you can maximize the benefits of diversification by owning investments across various geographies. Individual countries can perform poorly.
Owning assets across various businesses, sectors, and geographies will minimize non-systematic risk without reducing expected returns.
What is Not Diversification
It can be useful to run through some examples of failed diversification:
- Investing 50% of your portfolio in an Electric Vehicle Exchange Trade Fund (Industry concentration)
- Placing 50% of your portfolio in TSLA stock
- Investing a large chunk of your portfolio in stock of the company that you work at. It’s highly risky to concentrate Human Capital and Financial Capital in the same company.
The Benefit of Diversification
You do not receive higher expected returns for taking on extra company-specific or geographic risk.
I see don’t take on risk that I will not get paid for. That seems silly. Global diversification removes risk specific to individual businesses or countries while leaving expected returns unchanged.
Diversification is the only free lunch in investing. It gives you the maximum return for a given level of risk.
How to Diversify: Total Market Index Funds
Diversification has never been easier. I access thousands of stocks and bonds around the globe with low-cost index funds.
And I’m talking specifically about total market index funds. These funds hold all stocks that make up a stock market. Big stocks, small stocks, and stocks across the various sectors.
Many indices are produced with narrow sector concentration. don’t be fooled; these index funds still leave you exposed to plenty of non-systematic risks that you are not compensated for.
Globally diversified total market index funds eliminate nearly all non-systematic risks of specific businesses, sectors, or countries. This leaves you with the systematic risk of the global equity market and maximizes returns for a given level of risk.
Risk and Returns
Why Do You Get Paid for Taking on Risk?
Taking on risk is hard. You need to delay today’s spending and put your hard-earned money at the risk of loss.
The market pays you to take this risk in the form of future expected returns. You are only paid for the systematic risk.
How To Alter The Risk of Your Portfolio?
You can engineer your portfolio to match your unique ability and willingness to bear risk by changing the mixture of stocks and bonds in your portfolio.
This mixture of stocks and bonds is called your asset allocation.
Stocks are riskier (more volatile) than bonds. Therefore, they have higher long-term expected returns. Since 1900, global stocks have outperformed global bonds by 3.1%/year (source).
The only way to increase risk past that of 100% stocks is through use of leverage. You could also hold more value stocks in your portfolio – value stocks are riskier than growth stocks.
Asset Allocation and Returns: The Relationship
The historical returns of various asset allocation mixes over the last 50 years can be found in the Model Portfolios on the Canadian Portfolio Manager Blog.
These returns are for a globally diversified portfolio of stock and bond index funds, with a heavier weight towards Canadian stocks and bonds.
Note the lowest 1-year return. This is a measure of volatility.
30 Year Annualized Return
Lowest 1 Year Return
Notice that bonds provide more short-term portfolio stability, and that this stability comes at the cost of lower long-term returns. You pay a price to sleep well at night.
You can see the worst-performing historical periods for various asset allocations in this post. It will give you an idea of why time horizon is important, and what to expect for market downturns.
How Much Investment Risk Should I Take?
Everyone has a unique risk tolerance based on a unique financial situation and a specific emotional response to financial loss. We all view money differently depending on our interactions and observations with money growing up.
Your unique “risk tolerance” represents the amount of investment risk you are able and willing to take.
Your risk tolerance depends on two unique factors:
- Your ability to take on risk; and
- Your willingness to take on risk.
Your ability to take on risk is rooted in your circumstances, while your willingness to take on risk is based on your emotional sturdiness in the face of temporary financial loss.
Let’s look at these two factors in more detail.
Ability to Take Risk
Your ability to take on risk is related to your need to access your investment money for consumption. In general, your ability to take risk boils down to how much of your portfolio you must withdraw, and when you must withdraw the money.
The factors that influence your ability to take risk are:
- Time Horizon: How long you can stay invested before you need the money. A long time horizon increases your ability to ride out the ups and downs of volatility.
- Income Stability. Stable earnings reduce the risk that you will dip into your investments.
- A Properly Sized Emergency Fund. This is a must before investing in even the safest asset allocation (bonds). It permits you to fund emergencies without dipping into your portfolio during market downturns.
- Debt: Mortgage and student loan debt will reduce your ability to take risks. Viewed another way, investing with debt is like leverage, which increases your risk.
- Savings Rate: A measure of income relative to expenses. See this post for more on the savings rate.
Willingness to Take Risk
Your willingness to take on risk is psychological.
This is your ability to maintain a rational frame when investing, to prevent panic selling and jumping into speculative assets out of FOMO.
A good measure of your willingness to take risks is how well you sleep at night during market ups and downs.
Willingness to take on risk is based on:
Your understanding and acceptance of your human biases.
The systems and habits you have in place to reduce the intensity of emotional response to market turmoil.
The depth of your understanding of where stock and bond returns come from.
Your ability to control your human biases through self-discipline.
For more reading, check out this post on 7 Ways to Control Your Emotional Biases.
Willingness to Take Risk and Portfolio Size
As your portfolio size grows, the up and down fluctuations will hurt more. A 10% loss on a $10,000 portfolio is $1,000. But a 10% loss on a million-dollar portfolio is $100,000.
Therefore, your willingness to take risk becomes more important as your portfolio increases in value.
It is dangerous to invest in an asset allocation that exceeds your willingness to take risk. You may panic sell in a market downturn. Or, you may chase returns and over-trade.
A Test of Your Willingness to Take Risk
Ask yourself: What would I do if I lose 50% of my investment portfolio, and had to wait 5 years for it to recover?
If your response is to sell everything and never invest again, you do not have the willingness to take on the risk of 100% equities (stocks).
Estimate Your Asset Allocation
This Investor Questionnaire by Vanguard can help you estimate your asset allocation based on your unique ability and willingness to take risk.
Estimating your asset allocation can be hard. It is one of the core duties of a financial advisor. Even then, sometimes you need to experiment to find your unique risk tolerance.
In the process, you’ll get to know yourself better. Then you can adjust your risk tolerance based on how well you sleep at night.
Willingness to Take Risk: The Limitation
I assume you are relatively young with at least 20 years of investing time ahead of you before retirement.
You have a long time horizon ahead of you if you are under 40. Plus, you have strong earning power ahead of you.
Therefore, your willingness to take risk is the limiting factor, because you likely have a strong ability to take risk.
Risk – volatility – is the choppiness of the price of your investments. The volatility comes from uncertainty in the future cash flows of the investment or pool of investments. This investment can be a stock, bond, cash-flowing real estate or a fund of these assets.
You are rewarded for taking on more systematic risk. The reward comes as higher future expected returns. But don’t be fooled. You are not paid to take on additional risk that could easily be diversified away.
An understanding of risk may drive you to consider low-cost index investing. Not only does index investing optimize the risk-return tradeoff, but it is also hands-off and dirt simple.