The Four Letter Word ..... Risk
In financial and investment planning, that four-letter word, "risk," is something we constantly grapple with. Following the too-calm markets of 2017, the return of volatility in 2018 stunned many investors.
All investments are subject to risk. A bank savings account is subject to the risk of failing to keep up with inflation. Bonds are subject to the risk of rising interest rates and defaults. Stocks bear the risk of a company's business and financial structure. Even diversified portfolios are subject to the whims of the overall market. Economic, political, tax, and regulatory changes pose a risk to all investments.
Since no investment is immune from risk, the only thing an investor can do is to decide which risk or what type of risk they are willing to embrace and what they want to avoid.
However, even this is not an easy thing to do. Let's examine some of the terminology surrounding risk.
Risk vs. Volatility
Risk is the real danger of losing principal, such as a bond going into default or the stock of a company being permanently damaged. Volatility is the day-to-day movement of financial markets. The two terms are connected, but for most investors, it is the volatility of markets, not the actual risk of their investments, that causes most of their heartburn.
Risk Tolerance
When we speak of "risk tolerance," we are normally referring to a person's emotional capacity to withstand risk. A person with "high risk tolerance" can, presumably handle the ups and downs of investments without freaking out, while someone with "low risk tolerance," might panic at the first sign of a decline in their investments. However, a person's risk tolerance often changes. During boom times, we often feel braver and may think we have high risk tolerance, only to discover, when times get tough, that we really don't.
Risk Capacity
You may have a high emotional tolerance for risk, but what is your financial capacity to handle risk? If you are still funding your portfolio, you arguably have a higher financial risk capacity, because you might have many years before you need to begin withdrawing from your investments. If you are retired, some portion of your portfolio might be held in less-volatile investments to fund your spending needs for a reasonable period of time, while you may have greater financial risk capacity for the remaining portion.
Risk Perception
Do you know a risk when you see it? We often misjudge risks - thinking a particular type of investment is low-risk, when its real risk may be much higher, and vice versa. We may also misunderstand the frequency and severity of the various types of risks inherent in our investments. For example, you may think of yourself as a risk averse investor with low risk tolerance, but choose a poor investment that you perceive as being low-risk, when it really isn't.
Required Risk
What risk do you need to take in order to reach your financial goals? Invest too conservatively and you may fail to reach those goals - and that is a risk itself! On the other hand, if your goals could be achieved with a 4% return, but your investment goal is an 8% return, you are taking on more risk than your goals require, which leads us to the next type of risk.
Risk Preference
Suppose you have an hour to drive from Raleigh to Durham. You can stay within the speed limit and make it with time to spare - but will you? Some people will just naturally drive a bit faster than required, because that is their preference. So, if your financial goals only require a 4% return, but you decide to aim for a higher-risk, 8% return, it is due to your risk preference.
Where does all this leave us?
If you are a bit confused, you should be! Understanding the multifaceted nature of investment risk, and the constantly changing nature of our own emotions and perceptions is a lifelong and difficult task. The philosophers who reminded us to "know thyself" never said it would be easy.
Gerald A. Townsend, CPA/PFS/ABV, CFP®, CFA®, CMT is president of Townsend Asset Management Corp., a registered investment advisory firm located in Raleigh, North Carolina. Email: Gerald@AssetMgr.com