Investment Risk – It’s What Makes the World Go Around…

5 October 2015


What’s the standard definition of investment risk?

Look for a standard definition of investment risk and you may find a definition that reads something like this:

“Investment risk is the chance that an investment‘s actual return will be different from that which was expected (broadly referred to as volatility of the investment). It also includes the possibility of losing at least part, and in some severe cases, all of the investor’s original capital sum. “

More often than not this textbook definition of “investment risk” is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment (measured against the market as a whole).

Making very complex maths simple, a high standard deviation indicates a high degree of risk. Applying the text book definition the comparative volatility of an investment is a large part of what investment risk is.

What is investment risk really?

Focusing on the volatility of an investment by measuring its standard deviation (or Beta) against the market perhaps clouds the issue of what investment risk really is.

Sometimes it is better to keep things simple.

Go out onto the street and ask the average investor what they fear the most and the majority will respond “the loss of my savings or capital”.

If that is the case then a better real life definition of investment risk would be:

“Investment risk is the potential to lose money on an investment permanently.”

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Permanent loss is very different from volatility or fluctuation in the value of an investment. Any downward fluctuation in an investment is by definition temporary and doesn’t actually present a problem for the average investor if he is able to hold onto the investment long enough to come out the other side when the investment rebounds.

Why you must embrace risk with open arms – but be prudent!

Many investors are so risk averse and conservative in their investment strategies that they shun risk at every available opportunity.

This is perhaps the worst investment sin of all since it exposes the investor to the greatest risk:

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No one knows what will happen in the future, and no economic model however sophisticated it may be, can ever capture what will actually happen tomorrow let alone in six months. Put another way what happened yesterday is known because it is history or prelude. What happens tomorrow nobody knows because it is the future.

This does not mean that we should shun the unknown or that we should fear tomorrow.

A prudent acceptance of risk is far superior to shunning the unknown. Risk must be taken otherwise there will be no return.

The great unknown future

The economist John Kenneth Galbraith once said “there are two classes of forecasters. Those who don’t know the future, and those that don’t know that they don’t know the future.”

Putting the issue of investment risk aside for the moment, many factors can influence just general future events. Government policies, individual spending patterns, and changes in commodity prices are three key examples that we see impacting the daily lives of people in the Republic of Trinidad and Tobago as you read this blog entry. No-one can predict what will happen to these three items in the future although we can perhaps make educated guesses about what may happen moving forward.

Beyond this the world can be influenced by events that are not on anyone’s radar or contained in anyone’s predictions. Take 9-11, take the 2004 tsunami, take the Fukushima disaster, as three classic examples.

Turning back to investments; did anyone predict how Blackberry would come along and destroy Nokia’s market share of the business phone market, and how Apple would do the same thing to Blackberry a few years later with the iPhone?

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Consider this: when the first iPhone was launched in 2007 Nokia was worth $114 billion and Blackberry $40 billion. Roll the clock forward and we find that Nokia was sold to Microsoft in September 2013 for $7.17 billion, and move forward to the current day (and at the time of writing of this blog) RIM has a market capitalisation of just $3.9 billion.

Did anyone or any model predict that?

Why is risk important to the average investor?

Risk is an integral part of investing, and ignoring the text book definition captured above, is essentially the counterbalance of return.

If you have ever heard the quote “there is no such thing as a free lunch”, this is the perfect example. After all if you make an investment would you really expect the returns to come to you at no cost (either real or potential)?

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Why people and in particular companies are becoming increasingly focused on risk

Many companies now allocate large amounts of money and time in developing risk management strategies to help manage risks associated with their business and investment dealings. A key component of the risk management process is risk assessment, which involves the determination of the risks surrounding a business or investment.

This is something we will turn to next week.

Ready to make some investments?

Firstline Securities Limited offers comprehensive coverage of local and international markets with a bias for the energy sector (yes, we know risk!). Firstline offers a number of unique opportunities to put surplus cash to work, whatever your risk appetite, either as your asset manager or investment advisor. Please contact us for more details at info@nullfirstlinesecurities.com or at 868.628.1175; we can discuss your investment needs in detail and craft a portfolio that makes sense for you. We look forward to hearing from you.

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