Wednesday, April 10, 2013

Investment Risk

Investment risk is defined as a deviation from an expected outcome. We can express this in absolute terms or relative to something else like a market benchmark. That deviation can be positive or negative, "no pain, no gain." In order to achieve higher returns in the long run you have to accept more short-term volatility. How much volatility depends on your risk tolerance - an expression of the capacity to assume volatility based on specific financial circumstances and the propensity to do so, taking into account your psychological comfort with uncertainty and the possibility of incurring large short-term losses.

Those who are just starting off saving for retirement also need to think about investment risk. While academics and investment professionals struggle to define and measure risk, most ordinary people have a pretty clear understanding of it – what is the chance that I'm going to lose a substantial portion of my money.

It is recommended that new savers and investors be realistic about risk. While any amount of savings is a good start, small amounts of money are not going to produce livable amounts of income in the future. That means that it makes very little sense to invest in fixed income or other conservative investments right at the beginning. Likewise, you don't want to destroy that initial savings right off the bat, so avoid the riskiest areas of the market - no biotech, no gold, no leveraged funds, and so on. A basic index fund (a fund that matches a popular index like the Dow Jones Industrials or S&P 500) is a good place to start; there's certainly a risk that the price will fall, but odds of a total wipeout are nearly zero and the odds favor a reasonable amount of growth.

Risk is inseparable from return. Every investment involves some degree of risk, which can be very close to zero in the case of a U.S. Treasury security or very high for something such as concentrated exposure to Sri Lankan equities or real estate in Argentina. Risk is quantifiable both in absolute and in relative terms. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs and costs involved with different investment approaches.