Understanding Investment Risk

Risk is the possibility of losing money or underperforming expectations. Understanding different types of risk is essential for protecting and growing your wealth. [DEFINITION] Investment Risk: The probability that an investment's actual returns will differ from expected returns, including the possibility of losing some or all of the original investment. ### Types of Investment Risk **Market Risk (Systematic):** Affects the entire market—cannot be diversified away. - Economic recessions - Interest rate changes - Geopolitical events - Pandemic shocks **Company-Specific Risk (Unsystematic):** Affects individual companies—can be diversified away. - Management problems - Product failures - Lawsuits - Competitive losses [KEY] You can eliminate company-specific risk through diversification, but you cannot eliminate market risk—you're paid (via returns) for accepting it. ### Measuring Risk **Standard Deviation:** Measures volatility—how much returns vary from average. **Beta:** Measures sensitivity to market movements. - Beta 1.0 = moves with market - Beta 1.5 = 50% more volatile than market - Beta 0.5 = 50% less volatile than market [FORMULA] Expected Move = Stock Beta × Market Move [EXAMPLE] Stock with beta 1.5, market drops 10%: Expected stock move = 1.5 × (-10%) = -15% **Maximum Drawdown:** Largest peak-to-trough decline. [TIP] Maximum drawdown is more intuitive than standard deviation. Ask yourself: "Can I handle a 50% portfolio decline?" That's real risk assessment. ### Risk vs. Return Tradeoff **Historical returns by asset class:** | Asset | Annual Return | Volatility | Max Drawdown | |-------|--------------|------------|--------------| | Stocks | 10% | 15-20% | -50% | | Bonds | 5% | 5-10% | -15% | | Cash | 2-3% | 0% | 0% | [WARNING] There's no reward without risk. "Safe" investments with high returns usually have hidden risks. ### Risk Tolerance Assessment Consider: 1. **Time horizon:** Longer = more risk capacity 2. **Financial situation:** Stable income = more capacity 3. **Emotional ability:** Can you sleep during crashes? 4. **Need for returns:** Goals requiring high returns may force risk **Risk tolerance changes with:** - Age (decreases) - Life events (marriage, kids) - Market conditions (often irrationally) [EXERCISE] You have 30 years until retirement and stable income. Your friend has 5 years until retirement and variable income. Who should take more stock market risk and why? |ANSWER| You should take more risk. With 30 years, you have time to recover from crashes. Your stable income provides security. Your friend needs capital preservation—a 50% crash with 5 years to retirement could be devastating. [SCENARIO] You invest your portfolio in stocks. A year later, it's down 30%. You can't sleep, you check prices hourly, you're considering selling everything. What does this tell you about your risk tolerance? Your actual risk tolerance is lower than you thought. Many investors overestimate their tolerance during bull markets. The solution isn't to sell at the bottom—that locks in losses. Instead, after the market recovers, adjust your allocation to something you can actually tolerate (perhaps 60% stocks, 40% bonds instead of 100% stocks).