The risk of investing
In this post I will write about the risks of investing. What are real life synonyms of risk, how we define it and how you can try to minimize it. Lets start.
“Past returns are not an indicator for future performance.”
Everybody who has ever read something about financial instruments like ETFs, stocks or other derivatives has probably seen this statement. It basically means that if a stock, for example apple, grew the last 20 years, it does not mean it has to do so continuously. To be precise the past development of a stock has zero correlation to the future development of the stock in question. This is the message this statement tries to convey. However, some investing-principles claim someone can derive future share price developments from the historical data of said stock (yes I am looking at you technical analysis or short TA). Back to the apple stock example. There could be several reasons for apple’s stock to decrease in value (share price). They could have failed to release new, interesting products or a better product was released by another competitor. Also the markets could crash and pull the apple stock down with them.
Lets categorize these reasons into two groups. One is internal and the other one is external. In economic terms this means we have two type of risks.
- The market risk or systematic risk (basically the risk that the market shits the bed like 2001 or 2008 and pulls everything more or less down with him)
- The unsystematic risk which is basically the risk that a company (or specific part of the industry) doesn’t perform (e.g. a company not being able to meet their goals) and therefore the stock tanks.
Both the market risk and the unsystematic amount to the total risk.
You can do nothing about the market risk. Iff the market shits the bed, that is it. To be fair, some measures can be taken e.g. “hedging” but for simplicity’s sake let’s say that’s it.
However, reducing unsystematic risk is possible. By diversifying your investment it is possible to reduce the risk that a company can’t perform. For example by buying other competitors in the same industry. However, by doing that you will only focus on a specific industry so you should invest in other industries as well to diversify. Unfortunately this costs a lot of money if someone wants to diversify all his investments so ETFs might be a possibility. While this is true, diversifying for the sake of diversification is not good. If you have a few sound investments from different sectors you are probably good and don’t need to diversify no more. Diversification also has a point of diminishing return! Anyway, by investing in an ETF one can invest his money in a financial instrument which already holds several stocks from several industries. So without much trouble one can diversify their investment and therefore reduce his total risk. What’s the catch? A bit of risk always remains (market risk). By reducing the unsystematic risk one always reduces the potential returns as well.
Diversification and Expected returns
As the risk remaining part should be clear I will focus on the second part of the statement. By diversifying (having more stocks in one’s portfolio either by themselves or due to ETFs) someone always will get some bad performers as well. Due to this the average performance of the portfolio will also decrease. That is the reason why risk and potential return are proportional to each other.
While this is a horrible graph it at least gets the point across (hopefully). By taking on more risk one can increase his expected return and vice versa. You might wonder why there are error bars in the graph. All the time we talked about risk but couldn’t really grasp it. Now we can. The risk can be seen as the implied volatility of a stock. That means it equals the assumed range the stock will move around in. If the range is big then the stock is to be viewed as risky. If not it probably isn’t. Generally speaking a stock with a high volatility will fluctuate much while one with a low volatility won’t. There is a lot more to this but to be honest this is all you have to know about it for now.
So bearing all of this in mind there is definitely a risk to investing. Keep in mind that investments (often) should be held over a longer timeframe. If someone wants to buy e.g. a house and has all of his money invested he might have to sell his stocks in order to generate liquidity. This can be particularly unfortunate if the stock in question has performed really bad but it might rise again in the future. In this scenario someone might be forced to realize a loss in order to use the money from his investments.
To sum it up:
- There is a chance you will lose some part of your investment because there is no such thing as a perfectly safe investment even by diversifying (market risk remains)
- You can try to minimize your total risk by diversifying and therefore reduce the unsystematic risk
- By diversifying you might reduce your risk but also your potential returns
- The invested money can sometimes not be available (or sometimes you have to take a loss if you need the liquidity)
- Risk equals volatility
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