Are you taking enough risk? That’s an odd question to ask. We’ve been conditioned to believe that risk is bad and reducing risk is one of the most important tasks that an investor has to do. Why then am I asking if the readers of ValueResearchOnline are taking enough risk?
The reason for my question is an odd thing that I’ve noticed in the questions that readers send to Value Research. It seems that those who plan their investments most thoroughly are, more and more, avoiding almost all risk. A typical such investor will calculate his future needs carefully and then put money in bank deposits and government deposits of various kinds. If there is any equity exposure at all, then it will be to a small extent, through MIPs or such types of funds. Even young investors with good incomes and few short-term responsibilities are doing this.
Why is this wrong? Because risk and returns are two sides of the same coin. Because if you are taking too little risk then it is very likely that you are earning too little returns. And most importantly, if your investments look superficially low-risk, then it is quite likely that they are at risk of losing real, inflation-adjusted value in the long term.
If this idea of there being a level of risk that you must take doesn’t sit well with you, then it is likely that you are thinking of another, different type of risk; one which is so different that it constitutes a different meaning of the word. The dictionary definition of risk in investments is, “The chance that an investment’s actual return will be different than expected.” So it’s a measurement of chance, a probability.
The common understanding of risk is linked to volatility. If an investment’s value tends to go up and down a lot, like all equity, then that’s considered risky. If it goes up in a straight line, like bank deposits, then its not risky. This view is also enshrined in all mathematical measures of risk that are used in investments and portfolio analysis. Therefore, when ordinary investors start planning carefully and want to reduce risk, their first instinct is to choose investments that are less volatile and go up more steadily.
This is often a mistake. What matters to you is the value of your investment when you are in need of that money. What happens to it between the day when you invest and the date that you redeem the money does not matter. Therefore, the correct measure of risk is the probability of its final, realised returns being less than what could reasonably be expected over that time period.
Now comes the key -- the link between risk and returns. In all of investing, if there is one inviolable rule, then this is it: risk and returns go together. If you want higher returns, then you will have to bear higher risk. Investments that yield higher returns are almost always more volatile, and their value fluctuates a lot. However, if you wait long enough, much of the volatility gets damped down by the higher returns that result from the investments. It needs patience, and needs careful, sensible planning about your future needs. However, it does not necessarily mean less risk and therefore lower returns.
So, let’s not see risk as an unmitigated evil. It’s the twin of high returns and you are not going to find one without the other. It needs to be understood and harnessed to one’s needs.
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