Do you know anyone dumped too much money into a speculative stock at the peak? Or someone who panic sold their investments during the 2008 or COVID crash?
These actions are a symptom 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.
Investment risk 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.
You an also view risk as a measure of how “choppy” the investment is over time. The price of a risky investment will 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?
Risk stems 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.
The stock price goes down when the expectations of future dividends change. The stock price goes up when future dividends become more certain (less risky), and the stock price goes down when future dividends become less certain (more risky).
Now for the next logical question: What factors influence the certainty of the future cashflows of a company (stock)?
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 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 get avoid systematic risk. You are paid to take on the systematic risk because it cannot be diversified away. A risk that you get paid for is called 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. Complex 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.
Non-systematic risk, also called idiosyncratic risk, is the risk associated with individual companies or singular industries.
This is the risk that a single company will lose a $150,000,000 lawsuit, hire inept management, or get drowned out by competition.
You don’t get paid to take on non-systematic risk. Why would the market compensate you for taking on risk that can so easily be avoided?
Having all your eggs in one basket increases non-systemic risk. Don’t put all your eggs in one basket.
You can minimize non-systematic risk by investing in a large basket of stocks across different industries, sectors and geographies. This is called “diversification”. We will talk about it soon – I know your excited.
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.
I’ve made a pretty graph to show you how this works.
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Risk and Diversification
What is Diversification?
Individual companies can tank. Market sectors can perform poorly. Sometimes, entire industries or countries never recover. The Japanese stock market is a good example. It still has not recovered from its peak in 1989.
This (non-systematic) risk can be avoided by holding various investments across different industries and countries.
Diversification solves this problem. You can maximize the benefits of diversification by owning investments across various geographies. Individual countries can perform poorly.
This will minimize your exposure to 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.
The Beneit of Diversification
You do not receive higher expected returns for taking on extra company-specific or geographic risk.
I see no reason to take on risk that I will not get paid for. Global diversification removes risk specific to individual businesses or countries while leaving expected returns unchanged. This is why my portfolio is invested in globally diversified index funds.
Diversification is the only free lunch in investing. It gives you the maximum return for a given level of risk.
How to Diversify
Diversification has never been easier. You can access thousands of stocks and bonds around the globe with low-cost index funds.
Globally diversified index funds eliminate nearly all non-systematic risk, leaving you with the systematic risk of the global equity market. This investing style will maximize your returns for a given level of risk, because you are not taking risk that will not be compensated.
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 take on risk. This is one of the most important parts of investing. Risk exposure is controlled 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.
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 how much loss you can endure without ruining your financial situation. 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.
- Your Net Worth (Assets-Liabilities). Net worth can provide a buffer in times of loss.
- 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.
- Human Capital: Your potential for future earnings power (you are your best investment).
- Income Stability. Stable earnings reduce the risk that you will dip into your investments.
- Savings Rate: A measure of income relative to expenses. See this post for more.
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.
Willingness to Take Risk
Your willingness to take on risk is phycological. A good measure of your willingness to take risk is how well you sleep at night during market ups and downs.
Willingness to take on risk is based on:
- Your understanding of your human biases.
- Your ability to control your human biases.
For more reading, check out this post on 7 Ways to Control Your Emotional Biases.
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 will not be 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.