Life is full of risks. Is Investing Risky?
Yes*, investing can be risky.
*Not investing can also be risky.
The risk conundrum is that taking no risk is actually risky. This is because there are many forms of risk. Investing risk might be described as the uncertainty of future returns. A risk that is connected to investing is inflation – meaning the loss of purchasing power of a unit of money like a U.S. dollar. For example, if an investment yields a return that is lower than inflation, there is there is a negative real return resulting in an erosion of buying power associated with assets and income. In today’s market context, inflation risk is remarkably high.
There are other risks too. Consider market risk which is the tendency that all stock prices move together. Prices sometimes collectively move up and sometimes they move down, regardless of an individual company’s financial situation.
In an excellent video on risk, Ben Felix, a respected Canadian investment researcher (with a bit of a hockey accent), talks about several risk factors:
1. Total Loss – is it likely that an investor will experience 100% loss on their investment? If that investor holds a single stock, the possibility is much higher and distinctive than if they own a larger and more diversified portfolio of stocks. After all, it is much more likely that an individual company could go bankrupt than it is for an entire investment portfolio of hundreds of companies to suffer the same fate. Think about safety in numbers and diversification of a broad market benchmark like the S&P 500.
2. Volatility - big ups and downs in prices are hallmarks of volatility. But is volatility actually risky? It depends on the investment time horizon. If an investor has a 30-year investment horizon, then the volatility of today is of little import. However, if the investment horizon is less than five years, a high volatility stock or portfolio is considerably riskier. The variability of returns can cause major stress for some investors; therefore, investor psychology is very important. Some investors prefer a slower and steadier investment to one that can gain big and lose big. Other investors are okay with volatility because they believe in the long-term growth of the market. It’s critical to note that a more volatile portfolio is often expected to have a higher return. So, if you have the emotional fortitude for stocks, you might very well expect a better outcome than a lower volatility investment like bonds. This is just a starting point in the risk-reward relationship, so it is important not to overly simplify and assume that higher volatility alone is a recipe for higher investment returns. Another time, we will dive into risk-adjusted returns.
3. Skewedness – annual stock returns can be illustrated on a distribution chart revealing things like its average or mean return and all the years in which it was better or worse than the mean. See the distribution chart examples below. A “normal” symmetrical distribution has a mean in the middle and a relatively equal number of possible outcomes on the positive or negative side. Most stocks tend to illustrate a positively skewed outcome with a long tail to the right or positive side of the distribution chart. The result is that the extreme positive outcomes are far greater in magnitude than the negative outcomes. Consider the 2018 study, Do stocks outperform Treasury bills? The largest returns in the stock market over the past 90 years have come from an exceedingly small number of stocks. Approximately 4% of stocks are responsible for generating market returns higher than those of the Treasury bills (which are considered to be a “risk free” investment). Another way of saying this is that the vast majority of stocks did not produce better results than Treasury bills. The big takeaway in this research is that stocks do generate a large amount of wealth; however, knowing which individual stock will do so is extraordinarily hard to predict! These “results reinforce the desirability of having a well-diversified portfolio, which increases the chances that some of your stocks will become big performers.”
Graph Source: Wikipedia