Investment Risk: Balancing Risk and Return While Making Peace With Volatility

Nothing in life is without risk. And when it comes to investment risk, it is an inescapable aspect of investing and financial planning that every prudent investor must confront. Leaving your money ‘under the mattress’ as it were, putting all your funds into a ‘safe’ cash or money market account … to speculating on the latest crypto coin or meme stock all have inherent risks. Understanding how to manage risk is crucial for crafting a strategy that aligns with your financial goals and risk tolerance. Having recently read an article penned by one of world’s most accomplished investors (Howard Marks) – this piece delves into the nuances of investment risks, categorizes investments by their risk levels, offers real-world examples, and extracts wisdom from Howard Marks himself. It also clarifies the differences between volatility and the risk of permanent loss, and outlines strategies for achieving effective diversification.

understanding investment risk

Insights from Howard Marks

Howard Marks uses the game of chess as a metaphor to describe investment strategies, emphasizing the concept of sacrifice and risk. In chess, as in investing, strategic sacrifices are necessary to achieve long-term success. Marks describes:

Sham Sacrifices: Comparable to buying safe assets like U.S. Treasury notes, where the sacrifice (giving up higher returns) is clear and the outcome is relatively certain.
Real Sacrifices: Involves taking on significant risks for the possibility of greater, though uncertain, rewards.
Marks’s philosophy aligns with the famous maxim “No risk, no reward.” He argues that avoiding risk is often the riskiest strategy of all, particularly in a competitive investment environment.

Marks also highlights the psychological aspects of risk-taking, noting that a willingness to accept potential losses is crucial for long-term investment success.

The Risk of Not Taking Risk According to Howard Marks:

Because the future is inherently uncertain, we usually have to choose between (a) avoiding risk and having little or no return, (b) taking a modest risk and settling for a commensurately modest return, or (c) taking on a high degree of uncertainty in pursuit of substantial gain but accepting the possibility of substantial permanent loss. Everyone would love a shot at earning big gains with little risk, but the “efficiency” of the market – meaning the fact that the other participants in the market aren’t dummies – usually precludes this possibility.

Most investors are capable of accomplishing “a” and most of “b.” The challenge in investing lies in the pursuit of some version of “c.” Earning high returns – in absolute terms or relative to other investors in a market – requires that you bear meaningful risk – either the possibility of loss in the pursuit of absolute gain or the possibility of underperformance in the pursuit of outperformance. In each case, the two are inseparable.

The risk inherent in not taking enough risk is very real. Individual investors who eschew risk may end up with a return that is insufficient to support their cost of living. And professional investors who take too little risk may fail to keep up with their clients’ expectations or their benchmarks.

Types of Investing Risk

The core principle of investing is the relationship between risk and return: generally, higher potential returns come with higher risks. Key risk types include:

Market Risk: The risk of losses due to overall market performance.
Credit Risk: The risk that a bond issuer or borrower will fail to meet their obligations.
Liquidity Risk: The risk of being unable to sell an investment at a fair price quickly.
Inflation Risk: The risk that inflation will erode the purchasing power of returns.
Interest Rate Risk: The risk that changing interest rates will affect the value of investments.

Understanding these risks and aligning them with personal financial goals and risk tolerance is crucial for every investor.

Types of Investing Risk
10 of the major types of investment risk

Investment Assets By Risk Level: Comparing Risk and Return

The common way to categorize investments has been to put them into low, medium, and high-risk categories (or variations thereof). But investment risk and where investments fall on a risk spectrum (or ladder) is often a lot more nuanced – and depends on things like interest rates, where we are in an economic cycle, and overall mood or sentiment of the market (are we in a risk on vs. risk-off environment). Different investments might perform well or poorly based on some of these factors, which is why diversifying effectively remains the best strategy to optimize returns while reducing (note – not eliminating) these risks.

Further Reading: Timeless Investment Principles and Strategies To Achieve Long-Term Investing Success

When assessing the risk associated with various asset classes, it’s useful to envision them on a risk ladder, with each rung representing a step up in potential risk and return.

  1. At the lowest rung, we have cash, which offers minimal risk but also the lowest returns, primarily due to inflation.
  2. Moving up, government bonds from countries with strong credit ratings, like the U.S., are considered ‘safe’ investments due to their stable financial backing, yet they yield slightly higher returns than cash. In contrast, government bonds from countries with poorer credit ratings, such as South Africa, occupy a higher rung on the risk ladder due to increased default risk, offering higher yields to compensate for this risk.
  3. Next are corporate bonds (investment grade), which are riskier than government bonds from stable countries due to the potential for corporate financial instability, but safer than those from less stable countries.
  4. High-yield bonds, often referred to as junk bonds, present higher risk due to their issuance by companies with lower credit ratings, thus providing higher returns.
  5. Shares in large, established blue-chip companies are further up the ladder; they are more volatile than bonds but are generally considered safer than other equity investments due to the companies’ financial strength and market position.
  6. However, shares in smaller or more speculative companies are even riskier, as these firms are often more vulnerable to market fluctuations and financial uncertainties.
  7. Commodities like gold and silver represent a unique category; they can be volatile and are influenced by different factors such as market demand, geopolitical stability, and inflation, making them moderately risky.
  8. At the top of the risk ladder are crypto assets, which are highly speculative and subject to substantial volatility, but also have the potential for significant returns, reflecting their high-risk, high-reward nature.

Investing Risk Examples

Historical market events offer clear lessons on the impact of risks. For example, the 2008 financial crisis demonstrated how intertwined and globally systemic financial instruments can lead to widespread market failures. Similarly, the dot-com bubble and the COVID-19 market volatility showed how quickly excess can turn into a downturn, and how markets can recover and grow over time.

Investing in equities (stock market) has proven to be the most reliable way of achieving wealth over time if done sensibly and with a large degree of patience … and the ability to withstand those deeply uncomfortable periods (bear markets) like those referenced above where equity markets can fall 50% or more in value.

Understanding Volatility Risk vs. Permanent Loss of Capital

Investors often face two distinct types of risks: volatility risk and the risk of permanent loss of capital. Volatility risk refers to the temporary fluctuations in the value of investments or markets. It is characterized by price movements that, while potentially unsettling, generally allow for recovery over time, assuming the investor remains patient and the underlying investment fundamentals remain intact. Think of an index like the S&P 500 which can (and has) fallen by more than 50% in value … yet despite these sell-offs still manages to average returns of about 10% p.a. since WW II. Or even a share like Amazon that fell more than 90% in value during the time of the dotcom bubble and has gone onto become one of the best investments over the last 20 years.

On the other hand, permanent loss of capital occurs when the value of an investment does not recover, leading to a definitive loss. This is also often attributable to investor behaviour – selling at inopportune times and not giving an investment the opportunity to recover. This type of risk is typically associated with speculative investments or an overly concentrated strategy, where investments are heavily loaded into a few securities or sectors. Lack of diversification can amplify the impact of adverse events on these investments, resulting in lasting financial damage. Understanding these risks and how they can affect investment outcomes is crucial for developing a resilient investment strategy.

Companies like Eastman Kodak or even more recently Blackberry are examples of once highly regarded businesses that have become obsolete (overtaken by new technologies) and seen shareholders lose everything (or almost everything.) A great local example is Steinhoff which was more about fraud and mismanagement – but which does also occassionally happen.

Ways to Reduce Investment Risk: Diversification Is the Only Game in Town

Individual Stock Diversification

Academic theories, like those propounded by Harry Markowitz in his Modern Portfolio Theory, suggest that diversifying an investment portfolio across a broad range of stocks reduces the unsystematic risk associated with individual stocks. For instance:

20 Diverse Stocks: By investing in a minimum of 20 different stocks from various sectors and industries, an investor can significantly reduce the risk of permanent loss. This approach ensures that even if one or two stocks suffer a decline or failure, the overall impact on the portfolio is cushioned by the other performing assets. For example, an investor might choose stocks across technology, healthcare, consumer goods, energy, and financial sectors to create a balanced portfolio with reduced exposure to sector-specific downturns.

Unit Trusts/Mutual Funds

Unit Trust funds offer a convenient way to achieve diversification, as they typically hold a wide array of securities (shares, bonds etc):

• Mutual Funds with 50-100 Securities: A mutual fund that invests in 50 to 100 different securities spreads out risk much more than an individual stock portfolio can. For example, a balanced mutual fund might hold a mix of stocks, bonds, and other assets, across different industries and geographic locations, thereby hedging against the risk of a significant loss in any single investment.

Index Funds and ETFs

Index funds and Exchange-Traded Funds (ETFs) are perhaps the most straightforward ways to achieve broad diversification:

• Index Fund or ETF: Investing in an index fund or an ETF that tracks a major index, such as the S&P 500 or the NASDAQ-100, automatically provides exposure to hundreds of different companies. The S&P 500, for instance, includes 500 of the largest companies in the U.S. across all major industries, which significantly disperses investment risk. The performance of these funds tends to mirror the overall market performance, thereby mitigating the risk of permanent loss due to the failure of any single company.

Diversification Example: To create a diversified investment portfolios using ETFs, you might combine different equity ETFs represending different geographical regions like the US, Europe, Asia, Japan and Emerging Markets – and to reduce risk or volatlity – add ETFs from different asset classes like bonds, property, gold etc

Asset Allocation and Investment Volatility: How That Translates to Investment Risk and Return

Diversification helps in reducing the risk of permanent loss as it avoids over-concentration in any single investment or sector. It is one of the key principles of risk management in investing. By spreading investments across different assets, sectors, and geographic regions, a diversified portfolio can withstand market volatility better and recover from downturns, thus preserving capital over the long term.

Asset Classes and Investment Diversification

This is a useful image published by Fidelity in the US that illustrates how asset allocation impacts performance and volatility. The point is the most aggressive growth portfolio (most heavily weighted to stocks) experiences the most extreme volatility (look at best-and-worst 12 month returns) – but produces the best average annual return.

The Conservative Portfolio which has a much lower stock allocation relative to bonds and short-term investments is a lot less volatile – but its average annual return is signficantly less than the aggressive portfolio.

That translates to the following end values over a 20-year investment term assuming an investment amount of $100K:

Conservative (5.75% p.a.) = $315K

Balanced (7.74% p.a.) = $468K

Growth (8.75% p.a.) = $572K

Aggressive Growth (9.45% p.a.) = $657K

Even with a gut-wrenching, stomach turning 60% fall in value for the aggressive growth portfolio along the way (and other less severe drawdowns no doubt too) – if you can withstand the volatility and stay invested through the turbulence, you give yourself the opportunity to achieve the best long-term returns.

Conclusion

Investing inherently involves risks, but understanding these risks and employing strategies such as diversification can help manage them effectively. By learning from seasoned investors and applying robust financial principles, investors can navigate the complexities of the market and work towards achieving their financial goals.

Carl-Peter Lehmann

Carl-Peter Lehmann

Carl-Peter is a Director and Partner at Henceforward. He is an investment professional and CERTIFIED FINANCIAL PLANNER with over 20 years experience, having previously worked for some big global institutions managing large client investment portfolios.

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