Risk is your friend - you should manage it, not avoid it: Part 1/2

Risk is one of the most complex things in investing. It’s complex because so many people, from my experience, confuse fear and risk. Most investors believe that risk is the chance that you’ll lose money. That makes a “low risk” investment something like Government bonds, whereas a “high risk” investment might be, these days at least, crypto.

This two-part wire will walk through why you can’t avoid risk, ever - all you can do is decide which risk or risks you take on, decide how much risk you get exposed to, and then manage that risk exposure.

Let’s get started - what is risk?

The definition of risk within the context of investing is that you get results that are different from results that you would reasonably expect. It is often measured by your standard bell curve matched to a mathematical concept called standard deviation. The more standard deviations you are away from the expected result, somewhere around the high point of the bell curve, the higher the “risk”. For example, if you buy a 5-year bond and it yields 4%, you should expect to make a total return of 4% a year for the next 5 years. But if interest rates shoot up and the value of your bond falls from $100 to $85, you made $4 of income that year but you lost 15% in value. You didn’t expect that, and the standard deviation of that result will be high. Said differently, whilst the bond might not be risky, the risk in this specific event was high.

But that’s one kind of risk, there are many others and frankly, they’re often ignored. Risk such as:

• Liquidity risk
• Inflation risk
• Market risk
• Credit risk
• Currency risk
• Counterparty risk
• Regulatory risk
• Management risk

That list aside, losing money is the doozy of all "risks" so let’s look at that quickly. 

If someone decides to not invest in the stock market because it’s too “risky”, they may choose a term deposit instead. Let’s say the term deposit pays 5% per year. Now, it hasn’t paid that for a long time until quite recently, but I want to be very illustrative of my point here.

One of the world’s largest ETFs that tracks the MSCI World stock market index is up 20.26% in the last 12 months (through 30 Jun 2024). It’s all AI froth, I hear. Maybe, but it's also up 11.98% per year over the last 5 years, and 9.38% over the last 10 years. Both time periods are pre-AI. Choosing the "less risky” option has suddenly become quite risky in that you’ve massively compromised your investment goals. If you’re 35, 45 or even 55, you almost certainly can’t meet your retirement goals with a 5% return. Never mind that you’ve ignored one of the all-time omni-present risks, especially now – inflation risk.

The asset class with the best track record of beating inflation, hands-down and over a long time, is global stocks. And as markets evolve, it might be that the broad private markets asset class joins in soon too. It’s interesting because this happens all the time – that an investor chooses what feels like the lower risk option only to have it turn out to be quite high risk. Just not the original risk they were thinking of.

And that’s what I mean, that’s where investors often confuse fear and risk. This is important because when it comes to investing, there are no risk-free options.

Not one.

People talk about the “risk-free rate”, and that’s often proxied by the 10-year US Treasury bond rate. But let’s be clear – that bond is not “risk-free”. It fell over 3% in 2021 and it fell another 15% in 2022. Back-to-back loss years for high quality bonds are rare, so it turns out that the 10-year US Treasury bond has been very risky of late. It’s down again in 2024, by about 2% through 30 June.

That’s the world’s supposedly safest asset, down 3 of the last 4 years, and down almost 2% per year over the last 5 years. Interesting, right?

I’ll post Part 2 later this week and cover this idea of “low risk” options. Hint.....real estate is not low risk.

Good luck out there.