Risk vs Return
Risk and return are two sides of the same coin
You cannot consider one without the other. Typically, the more risk you take, the bigger your potential returns (note ‘potential’ returns).
The riskiest ‘investment’ you can buy is probably a lottery ticket- you’re almost certain to lose all your money, but if you do win the returns are huge.
The safest investment is probably cash in the bank- you’re almost certain not to lose any money (apart from inflation), but you also know you won’t make much from the interest the bank pays you.
Remember this when your friend tells you how much money he/she has made investing in stocks, crypto or anything else. Without understanding the overall risk involved, the return number means nothing. If someone generated 200% in a year while taking reckless risks (such that you were statistically highly lucky and your results are very unlikely to be repeated), then that’s not necessarily impressive.
How do you measure risk?
There’s one big problem with risk- it’s extremely hard to measure.
Many investment approaches give risk numbers and risk scores, but risk isn’t a concept that can be quantified even after the events have happened. So numbers and scores are largely irrelevant, because they are subjective. (We’ll visit this again later).
What have we learnt so far:
risk is vital and must always be considered
risk is impossible to measure, either before or after an event
Obviously that isn’t a helpful start. So what actually is risk? In short, it’s what’s lurking in the dark after you’ve thought of everything else. It’s the thing you can’t see or predict.
How to approach risk
Accept that risk is crucial yet you can’t measure it. So instead think about it logically, rationally and intuitively.
You know that a lottery ticket is hugely risky, so that’s why you (hopefully) don’t invest all your money in the lottery. You know that cash is safe, so that’s why you (probably) keep a decent chunk of your money in cash.
In between is a whole grey area. A good suggestion is to always try to think in terms of the risk of capital loss- what’s the chances here that you lose some/all of my money. Making up for losses is a lot harder than generating gains (if you lose 50% of your money, you’ve then got to make 100% just to get back to where you started).
This approach needn’t be scientific nor overly complex. Take a rational step back and consider your opportunity costs (what else you could invest in), and a realistic expectation of what your potential downside is vs your potential upside. For most private investors that’s about as complicated as risk management needs to be.
If you’ve got £100,000 to invest, and you’re looking at stocks, it likely doesn’t make sense to invest more than £10,000 in any one stock, because you’re facing a lot of downside if any one of those goes under.
If you’re looking at investing in government bond where your return is almost guaranteed and your downside is limited, you can likely do more.
In addition to common sense, there are some basic tools you can use to reduce your overall risk.
Diversification as a risk reduction tool
Diversification (buying lots of different things) or ‘not putting all your eggs in one basket’ is often touted as one of the best ways to control risk. Yes there’s some logic to this, given that any investment involves risk, and you can spread that risk out through lots of things.
Only invest the amount into anything that you’d be comfortable losing, if you think there’s a chance you might lose your money. If you’re looking at a portfolio of stocks, this might be 5-10%. If you’re looking at your overall wealth, this might be even lower.
There’s a better way of controlling your risk than just buying lots of things. Instead, make sure whatever you’re investing in is actually good, high quality. Whether that’s stocks, bonds, properties, classic cars etc. Buying shares in 100 risky companies is not safer than buying 5 really good ones. So sure don’t put all your eggs in one basket, but also don’t get fooled into thinking that owning a lot of different things reduces your risk.
This is especially true with investment funds or indices- just because an index has lots of companies in it doesn’t mean it’s low risk. If most of those companies are highly risky and expensive, you’re taking a lot of risk buying that index. You’d be taking far less risk buying a small number of cheap and good companies.