The topic of Risk is one that is thrown around a ton when it comes to investing. As in much of life, investing requires us to deal directly with an unknowable future. Many attempt to quantify the risk they are taking with a certain investment in terms of Beta’s or Standard Deviations, which are measures that describe the volatility of an assets price relative to its history or some benchmark (e.g. S&P 500). Volatility certainly can pose a risk, particularly for someone that faces a need for their money other than investing in the near-term.
Of course, when questioning the risk associated with a particular investment or strategy, an appropriate answer might be “Which one?” There can be a variety of potential risks for investors to consider when putting their savings to work. Some might derive from currency movements, inflation, liquidity, partial or total permanent loss from bankruptcy or other events like shareholder dilution. Finally, given a significant psychological component of managing finances and investing, the risk of outsized emotional influence is very real as well.
Arguably, the most significant risk an investor might encounter is the inability to achieve their financial goals due to avoidable reasons, despite having the resources to do so.
“Risk means more things can happen than will happen.” -London School of Economics professor Elroy Dimson
What to do about it
One of the most powerful tools for mitigating many of the lists we mentioned above is diversification, whether across asset classes (stocks, bonds, real estate, etc.) or within them (e.g. owning a variety of stocks across different industries or sectors). In his book, the founder of The Prudent Speculator Al Frank, wrote, “The wider the diversification, the better – in order to minimize individual corporate (stock) risk, sometimes called unsystematic as contrasted with stock market or systematic risk.” Al’s commonsense notion that having only a small percentage of a portfolio at risk in any one position would hurt minimally if it worked against you makes intuitive sense to us and is a strategy we have implemented at The Prudent Speculator for more than 45 years.
Other tools exist that one may use in an attempt to mitigate systemic risk – which is generally used to refer to the possibility of a significant drawdown in the market as a whole. A non-exhaustive list of these tools might consist of options, hedge fund strategies, or even market linked products like annuities that have additional guarantees. Consider these to be comparable to insurance one might use to protect themselves for other types of risk.
Of course, like traditional forms of insurance (think life, home, or auto insurance), they aren’t without cost. And because of the nature of compound interest, even the smallest of these insurance costs in any given year can result in a massive drag on returns over the course of decades or a person’s lifetime.
Conclusion
We think a deliberate examination into one’s willingness or ability to entertain certain risks with their investment portfolio is an essential practice, whether beginning an investment journey or via check-ins along the way.
In summary, investors face a multitude of risks that can impact their portfolios in a variety of ways. Effective risk management is not about avoiding risk altogether but rather about recognizing and mitigating it to achieve financial goals. By understanding the myriad of risks, through strategic diversification and asset allocation investors can more effectively prioritize their goals and take steps mitigate or avoid the unnecessary.
Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. This report should only be considered as a tool in any investment decision and should not be used by itself to make investment decisions. Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.