Sunday, May 10, 2009

Understanding the risk

Understanding Risk (with stocks & shares)
A major risk you face, as an investor, is that what you buy will perform worse than you expect. Every investment in the known universe carries such risk (rising inflation can eat even the gold bars in the bank vault). You can't make a judgment about how bad the risk is, in a particular case, without considering both probability and scale. Consider a $1,000 investment that you believe will grow steadily over the coming decade. A 10% risk that its value will instead decline by 50% will be, for many people, far more serious than a 50% risk that its value will decline by 10%.

This is because risk isn't a statistical abstraction — what should be counted as a bad risk depends on your circumstances. Let's put it more graphically. Suppose I'm a bored billionaire, and I offer you a bet. I'll toss a fair coin once, and I'll pay you ten million dollars if it comes up "heads" and you only have to pay me one million if it comes up "tails." Mathematically, it's a no-brainer — I'm virtually giving money away. But in reality you'd have to be very wealthy too before this bet made sense. Why? Because, for us non-billionaires, an even chance of getting rich isn't worth an even chance of being financially ruined.

Some investments have a value that fluctuates a lot, these are said to be more volatile and (at least in the short run) more risky. Investments with more stable returns, or some insurance or guarantee behind them, are considered less risky. Investors commonly use asset allocation and diversification to reduce volatility, and thus the overall risk of their investment portfolio. To learn more about this, read Setting Goals and Staying on Course.

But notice that "riskiness" and "volatility" aren't necessarily the same thing. Sure, highly volatile investments are risky, but that's because they may fail, and their failure may prevent you from meeting your financial goals. Notice this: very low volatility investments, which fail to make significant returns relative to inflation, are also "risky" if they too prevent you from reaching key goals. In investing, being too conservative is also a strategy with risk attached.

So you need to risk some to make some. But you also have to consider your "volatility tolerance" — your financial (and psychological) ability to ride out market swings without sudden "panic" selling. People who are naturally conservative or risk-averse don't sleep well at night when the principal value of their investment, and possibly any growth they have obtained, seems to be evaporating. On the other hand, people with an aggressive investment attitude, who can ride out market downturns without panic, often put at least some of their money in more volatile investments. These can fluctuate wildly in the short-term, but they may offer superior inflation protection and long-term wealth-building prospects.

Which attitude you can afford to take depends crucially on your reserves. On "Black Monday" (October 9, 1987), the Dow lost over 500 points, almost a quarter of its value, in a single day. In conditions like that, with fully-grown brokers weeping and ruining their hand-tailored shirts, it was a lot easier to have steel nerves if you had a sensible reserve of cash, Certificates of Deposit, and other non-volatile savings to tide you over. Indeed, facing such a situation with all your assets in stock, and no cash in hand to buy next week's groceries, isn't investing — it's desperado gambling.

The best risk-reduction tool is knowledge. Never invest in something you don't understand. Always consider how an investment fits into your long-term goals. Always try to calculate, at least roughly, both the best that is likely to happen with a given investment and the worst — and take an honest look at how you feel about those prospects. Even a very good investment performance takes few people into the Rolls Royce showroom. On the other hand, even relatively bad performance should not force you into auctioning your furniture on E-Bay. Risk can't be eliminated, but it can be understood, respected, and managed.

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