We’ve been discussing risk often on this blog this year, trying to come at it from a number of different angles. It’s one of those core topics in investing that deserves all the attention it gets.
No doubt about it, risk is a big word in investing. Too big, in my view, to have much meaning unless one looks deeper and gets more specific.
Max Osbon recently pointed out four different flavors of investment risk. When you recognize which type(s) you identify with, you’ll have a better understanding of what kind of investor you are and how to approach your investments.
The Four Flavors
In order of increasing optimism, the four flavors of risk are:
Liability risk, or the possibility of losing more money than you actually have, is directly related to leverage, also called margin, in which you borrow money or securities to amplify your returns. More leverage, more risk. Too much leverage in the wrong direction or at the wrong time and you end up like Lehman Brothers, AIG, Bear Stearns, Fannie Mae or Freddie Mac to name spectacular examples – out of money, out of business, or bankrupt and probably at the wrong end of a lawsuit.
Investment liability risk is completely avoidable, and in my view, entirely unnecessary. My only advice here is just don’t borrow investment money. Period. That way, you cannot lose more than you already have.
Uncertainty risk is everywhere, quite common, and unavoidable. It is simply the risk of the unknown, which in general describes…life. Uncertainty risk in investing can be uncomfortable, such as when headlines are dire or securities prices seem to be in an unstoppable downward spiral (fueled by more dire headlines, of course).
How to deal with it? Relax, turn off the TV, enjoy your family, take the long view, let your money work for you, and stay disciplined. Easy to say and hard to do. Your investment advisor can help, by keeping you focused on long-term goals and long-term performance of different asset classes. Ultimately it is uncertainty that creates the possibility for positive returns; it is an essential long-term ally, even if it makes you anxious it in the short term.
Possibility risk is an optimistic viewpoint on the tradeoff between risk and return and how to use the former to get the latter. Investing more in stocks – generally riskier and higher returning securities – and less in bonds is a prime example of possibility risk in action.
Accepting more risk may improve your long-term rate of return, and have a huge impact over time. (See our post comparing a 5 percent and a 9 percent annual return over a generation.)
Possibility risk gets you thinking more specifically about your goals: How much money is enough? Am I getting the return I should? Will there be enough money when I need it most? Those are the really interesting and useful questions upon which your investment advisor builds your portfolio if you practice goal-based asset management, as we do.
Opportunity risk is the most positive and open-ended way to look at risk and use it to your advantage. This is an old philosophy, typified by the Chinese word for crisis, composed of the characters for “danger” and “opportunity.” Those who see risk this way not only accept risk, they embrace it – not for the thrill, but for the rewards it enables.
With opportunity risk we look at the link between risk and return to determine if we are getting enough return for the risk we are taking. (We use Windham optimization software to do this at Osbon Capital.) Opportunity risk is the mirror into which you gaze to determine what your risk tolerance is.
Risk is a matter of taste
It’s worth spending some introspective time as you mull these four flavors and savor what they mean to you as an investor. There is no right or wrong perspective on risk: a risk-averse investor is neither better nor worse than a risk-preferent one – just different. But self-awareness is important; the better you understand your risk palate, the better you can avoid some common pitfalls, which we discussed in another recent risk article – The Risk of Being Human.
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