This summer has been brimming with risk. With the oil sands wildfires in Canada, the Brexit vote, unpredictable violence around the US, and continued uncertainty of the presidential election, there’s certainly enough risk to go around.
Still, is investing riskier than usual? Probably not. While “normal” seems to be increasingly difficult to define, risk is definitely part of it.
Risk is an essential part of the investing equation, love it or hate—and we as investors do have a love-hate relationship with risk. But why?
1. We Don’t Take Risk Seriously
Risk as a concept and risk as reality are two very different things. We often romanticize the idea and idealize those who step out and take risks, but when it actually affects us, we’re not quite as infatuated with it.
The market is loaded with risk, which is actually a good thing considering that otherwise no one would make any money from investing. But many people tend to underestimate the growth power of risk and choose instead to just avoid the markets altogether. As Chuck Jaffe observed: “[A] common mindset is ‘I can accept risks; I just don’t want to lose any money.’”
But we can’t have it both ways. More money means you have to accept more risk of losing money. When the risk turns into reality, if you panic and sell, chances are you’ll take a huge loss. If you hold firm despite your fears, you could end up okay in the end, but the emotional distress might be beyond what some people can handle. Who needs that kind of headache?
2. We Take Risk Too Seriously
Nobody likes losing money, especially investors. As a whole, we are a loss-averse species, which means many of us will go out of our way to avoid financial risk, even if the likelihood of potential reward is great.
The more risk-averse among us have to be struggling to keep it together this summer. Wildfires, elections, Brexits, oil prices, ISIS…it’s almost too much to handle. But even if you sat by the phone with your finger on the “Sell” button, the markets would probably still adjust their prices before you could take action.
The markets ebb and flow far more quickly than anyone could conceivably trade on them with any measure of consistent profits. Yes, you should be aware of risk, but you shouldn’t try to eliminate it by outsmarting the market.
3. We Don’t Understand Risk
Often when bad news rears its ugly head, our fight-or-flight instincts kick in and tell us to run as fast as we can and don’t look back.
Investing is all about preparation. If you’re prepared well—with a diversified, carefully allocated portfolio that reflects your personal goals and risk tolerance—you’re usually better off disregarding news, both good and bad. This can be a difficult concept, but it helps if you understand the role investment risks play helping or hindering your overall investment experience.
Investors face these two vastly different kinds of risk:
Avoidable Concentrated Risks
These are the kind we’ve been talking about thus far. They come in and wreak targeted havoc on particular stocks, bonds, or sectors. In the science of investing, concentrated risks are considered avoidable. They will always happen, but you can offset their impact on your portfolio through diversification
Unavoidable Market Risks
As its name says, there is no getting around this kind of risk if you want to invest. Market risks are embedded in the markets and the process of investing. If you stuff all your cash under your mattress or in a safety deposit box, it will be free of such risks (although nothing is safe from inflation risk, but that’s a conversation for another day). As soon as you dip a toe into the markets, you’re exposed to market-wide risk that can’t be “diversified away.”
4. We Mistreat Risk
There is a happy middle ground somewhere between taking risk too seriously and underestimating its potential. If you lean too far either way, you could panic and sell out or sit out of the market completely, thus missing out on its long-term growth.
In contrast, disciplined investors who wait out the storms put themselves in a better position to be compensated for their loyalty with higher expected returns.
In many ways, managing your investments is about managing risk. Used properly, investment risk is a powerful tool as you build personal wealth. When misunderstood or poorly employed, it can work against you just as powerfully. But friend or foe, don’t be surprised when risk regularly challenges your investment resolve.
Respect and manage return-generating market risks. Avoid responding to toxic, concentrated risks. These are the steps toward a healthy relationship with financial risks and rewards.
To learn more about how risk affects your portfolio, check out our ebook, “Making the Markets Work for You.”
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