What Is Investment Risk?
To start the new year, our team goes back to basics and look at investment risk, no talk of PRIIPs, appointed representatives or FCA Umbrellas, but lots to come in 2019.
What is risk? Well, this depends on who you ask. Skydiving is ‘risky’ but so is walking down the street. Some investors will avoid the stock market, because it’s risky, but may occasionally gamble on sports. One thing we can agree on though, is that:
‘Risk is a four letter word!’
(In the English language, at least)
It’s difficult to work in finance without gently circling the idea of investment ‘risk’ and attempting to define it. Risk is in many ways a strange word, the very concept of risk can and will mean different things to different people and at different times in their lives. Users and abusers of financial services will have markedly different perceptions of what ‘risk’ is, what ‘risk’ was and the risks ahead. Even across different sectors of the investment industry what a practitioner may consider as ‘risk’ can also differ markedly.
Unhelpfully, the securities markets and financial market practitioners everywhere, alongside the world of financial risk management, have created many multiple definitions of risk which can add to, but also sometimes confuse our real-world understanding of the concept. It will be shown that risk is a word that is difficult to define exactly and has many different meanings depending on who you are talking to and when.
Some examples of risk definitions are:
“Risk is any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare.”
From FINRA – the US-based Financial Regulatory Authority
“In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks.”
From the SEC – The US Securities and Exchange Commission
In common usage, ‘risk’ is usually pejorative and has somewhat negative connotations – In everyday life unemployment, injury, ill health are all considered risks and risk is usually not described in a positive manner,
The sentences below use the word ‘risk’ in an understandable way, but also in a way that seems unusual due to the lack of a negative outcome.
There is a risk my health will improve
There is an increasing risk that I’ll be a millionaire by Tuesday
There’s a risk the holiday will be amazing
The risk of winning
The Oxford English Dictionary defines risk as ‘A situation involving exposure to danger.’
In finance, we think a little differently. To the economist or investment manager ‘risk’ is a more neutral term and refers purely to the possibility of more than one outcome. In other words, in financial language ‘risk’ is similar to ‘uncertainty’ and danger is implicit not explicit. When investing we can look at risk as a deviation from expected or known returns. This difference from the expected return can and will be either positive or negative. As savers we are concerned with the probability and magnitude of the deviation and understanding the probability of various outcomes.
Many people or investors, when they hear the term investment 'risk', may think of volatile equity markets and the frequency or potential for large stock market losses. Investors may also be concerned with the possibility of not getting all of their investment back when saving for the future. Whilst this 'capital' risk is important, it isn't the only type of risk that investors experience. Other types of risk to consider include potential loss of income, uncertainty over cash flows and the changing nature of money over time.
Ultimately, when you as an investor put capital to work in the financial markets or ‘at risk’ it can be difficult to say with any precision what returns will be like over any investment horizon particularly the long term. Whie the cult of equity means that for the long term investors large equity holding may be preferable, over any holding period asset prices are likely to fluctuate, often substantially, interest rates will vary and inflation is likely to erode the purchasing power of any cash or fixed cash flows. Currently the world is in a low interest rate regime. These low interest rates have created high prices almost universally across asset classes, but interest rates can change and asset price increases are not guaranteed to stay high. Investing is an inherently risky endeavour. But perversely when investing for the long term, it can be seen that underinvestment and taking too little risk can also be dangerous. Usually leading to worse outcomes than even a partially invested portfolio, as over time inflation (usually) erodes the value of money.