Understanding investment risk

Literally speaking, the word ‘risk’ is the possibility of a number of outcomes resulting from a given action. In the world of investing, the concept of ‘risk’ can differ based on an investor’s perception. There are a number of quantitative measures to determine the risk level associated with a given investment, and the industry-standard measure usually identifies risk as the degree of variation associated with the returns of investments, which is a concept known as volatility.

What is volatility?

Volatility is defined as the standard deviation of an investment’s return over a given period of time. This does not measure the direction of price changes, but merely their dispersion around the average level. An investment with higher volatility will have larger swings in value over the given period of time. For instance, if we take a portfolio with an expected average return of 10% per annum with annualised volatility of 6%, investors can expect the portfolio to generate a one-year return ranging from -2% to 22% (approximately 95% of the time), assuming the portfolio return is normally distributed.

Another useful quantitative indicator for risk measure is maximum drawdown (MDD), which is defined as the maximum loss from a historical peak to a historical bottom of a portfolio for a given period of time. MDD is expressed in percentage terms and is, essentially, the historical worst-case scenario for an investment over the given time frame. This measure is particularly useful for measuring downside risk for an investment.

However, if the interpretation of ‘risk level’ for an investment or portfolio relies solely on quantitative measures, such as volatility or MDD, this can result in challenging (or even misleading) conversations between investment advisors and their customers regarding investment strategy and client profiling. This is because investors often don’t see their risk in narrow mathematical terms, but rather as the prospect of an undesirable investment outcome, such as financial loss or failure to achieve their investment goals.

Here are some additional considerations which can help to understand different aspects of investment risk:

Inflation risk

Inflation risk means that, in a normal inflationary environment, the purchasing power of cash held in investor’s pockets would slowly erode over time. For example, when the investor put his/her money into a saving vehicle that generates a below-inflation return (after tax is paid), the real purchasing power of their savings is falling.

Shortfall risk

This is the risk of failing to meet a long-term investment target which could occur if an investor does not take on sufficient risk in their bid to get higher rewards, or if they invest in too many high-risk assets, causing their portfolio to lose too much value.

Economic/political risk

These refer to factors such as growth, employment, elections and international conflict etc., which are key drivers of investment performance, but at the same might correlate with job loss or income reduction. These risk factors are generally very difficult to fully mitigate for, given to their unpredictable nature. However, their impact can be reduced through a carefully constructed investment strategy. The simultaneous worst-case of income reduction and deep losses on the investment side can be an unbearable risk.

Liquidity risk

This risk describes the investor’s ability to buy or sell their investment in the market. This factor can substantially impact a portfolio’s return. For example, in a market where liquidity is poor, investor’s positive investment return can be greatly offset by their inability to liquidate the assets at the desired price level, due to the poor width and depth of the market. Moreover, liquidity could be interpreted as funding liquidity. If the investor has a loan to be repaid or an unpredictable payment and their wealth is locked into an investment, there is a high risk of fire sale of investments (at inefficient prices) or personal legal issues for the payments miss.

The bottom line

Ultimately, investments would not generate returns without risk. Anyone looking to get started with investing should see risk not as something to be avoided at all costs, but a necessary component of any long term strategy.

Risk also affects different investors differently. The longer your time horizon, for example, the more capacity you have for absorbing and capitalising on volatility in either direction. Any sound investment strategy will factor in different types of risk and attempt to navigate them with an analytical mindset. Get in touch with an investment advisor if you want to understand in full how risk could affect your own investment journey.

Spiral risk: Photo by Colin Carter on Unsplash