Risk plays an important part in everyday life. In financial terms, it defines the potential loss of capital. It has also been defined as volatility or divergence from a certain benchmark/index. But what exactly is risk?
Risk is commonly equated to volatility. Volatility is a measure of how an investment varies from its average over time. When we look at risk as volatility we undervalue the relationship between an investment’s price and its intrinsic value. It also ignores the risk associated with company operations and financial structure. The problem with this view is that volatility mostly indicates the fluctuation in perceived value based on past return patterns. Thus you get no indicator of other threats to returns. The best way to predict an investment’s returns is to compare the asking price to your estimate of its intrinsic value.
Another popular view on risk is that it’s a measure of divergence from some standard. This is measured by tracking error, which is defined by the statistical value of the difference between a fund’s and a particular benchmark. Therefore, share returns with high tracking indices are considered high risk. If your aim is to track the index or the best performing unit trusts, then this is a valid measure of risk, but investors who aim to create long-term wealth cannot use tracking error as a metric for risk.
Risk is loss of capital
In its simplest terms, is risk just not the probability of permanently losing your money? It is thus not just the loss, but also the magnitude of that loss that is important. This can be measured using the maximum drawdown, which is defined as the biggest peak-to-trough decline of a fund’s returns of a long-term time period. The time it takes for investments to recover is equally important. This is known as months to recovery.
Furthermore, the decline in a share’s price doesn’t ultimately increase the risk of capital loss if the drop is temporary and the probability of selling during this period is low.
Using this definition of risk means you should try to invest in companies whose share prices are well below their intrinsic value and ensuring that some margin of safety exists if things take a turn for the worst. Finding exceptional value will ultimately lead to lower risk and is generally the best strategy.
Be mindful when it comes to risk, but not afraid
Always thinking about risk allows us to identify potential problems, but also tends to drive us into taking a more conservative route. It is good to be mindful of the risks associated with investments, but try to not let it frighten you. Conservative is often a good direction as a strategy as it aims to preserve your money, but as the saying goes “no risk, no reward”. With the help of your financial advisor and fund manager you can evaluate your situation and compare it to your investment goals, which is your ultimate destination. Find the asset classes that fit in with your investment plan and risk profile. Being mindful, but not scared of, of risk will help you seek out the best long-term solutions to creating wealth.