This summer already is destined to deliver plenty of uncertain outcomes. On the political front, there are the especially stark contrasts found among the US presidential candidates. For better or worse, whichever candidate prevails is likely to set the tone for the country if not the world. The “stay or go” uncertainty surrounding the June 23 Brexit vote could also impact financial markets in significant ways. Then there are the usual suspects, such as oil prices, continued Middle Eastern unrest and so on and so forth.
So, is investing riskier than usual these days? In our experience, probably not. The problem is the mixed up, messed up relationship most investors have with the concept of risk. Risk and return go hand in hand – we want higher returns, but assuming the risk associated with achieving them is another story. This begs the question: why do we have such difficulty with the concept of “risk?”
We misunderstand the different types of risk.
There are two, broadly different kinds of risks that investors face: (1) avoidable, concentrated risks which can be minimized through diversification and (2) unavoidable market risks which you face when you choose to invest in the capital markets in any way, shape or form. We underestimate the amount of risk we can tolerate.
It’s one thing when we imagine risk and its potential impact on our lives and our investments. It’s quite another when it really happens. In investing, underestimating risk can trick you into believing that you can tolerate far more of it than you actually can. When the risk comes home to roost, if you panic and sell, it’s usually at a substantial loss. If you manage to hold firm despite your doubts, you may be okay in the end, but it might inflict far more emotional distress than is necessary for achieving your financial goals. Who needs that?
We overestimate the impact risk will have on our lives.
On the flip side, we also see investors overestimate risk and its sibling, uncertainty. We humans tend to be loss-averse. As such, we will go out of our way to avoid financial risk – even when it means sacrificing a greater likelihood for potential reward. Investors get into trouble when they overestimate the lasting impact that market risks are expected to have on individual investments and as a result avoid the markets altogether or shift in and out based on current events.
We think we must respond to risk.
Especially when colored by our risk-averse, fight-or-flight instincts, it may seem important to react to market risks by taking some sort of action – and fast. The fact is that the markets tend to price in the ebbs and flows of unfolding news far more quickly than you can trade on them with consistent profitability. While it is human nature to react to events (which serves us well in most aspects of our lives), it is one of the most dangerous things you can do as an investor.
Because of all of these misconceptions, we mistreat risk.
It’s a delicate balance – neither overestimating the impact of avoidable, concentrated risks nor underestimating the far-reaching market risks involved. Either miscalculation can cause you to panic and sell out or sit out of the market, thus missing out on its long-term growth. In contrast, those who stay invested when market risks are on the rise are better positioned to be compensated for their loyalty with higher expected returns.
In many ways, managing your investments is about managing the risks involved. Properly employed, investment risk can be a powerful ally in your quest to build personal wealth. Position it as a foe, and it can become an equally powerful force against you. Friend or foe, don’t be surprised when it routinely challenges your investment resolve.