We think of investment risk as similar to the multi-headed, serpent-like Hydra encountered by Hercules. Risk is multi-headed. It is also susceptible to mythical hyperbole. The modern investor is obsessed by risk to the point of madness. The trouble is that it is so badly misunderstood. Let’s stare it straight in its many faces: herein is a fuller and deeper understanding of the beast and its multifarious heads.
All too often risk is equated with volatility: a share, or fund, or bond is said to be more or less risky dependent on how much the price has wobbled around in the past. In the context of the Great Financial Crisis of 2008-09 it is easy to understand how this has come to be. Many stock markets halved in under two years: surely this must prove that investments where the price goes up and down are risky? Is it not true that you run the risk of losing money when you own an investment where the price may go up and down?
First, let’s think about investments where the price does not fluctuate. There are two types of these: cash and Ponzi schemes. An absence of volatility therefore means that you are choosing between a) making nothing and b) losing everything. Then let’s think long-term; markets will always be markets. Bad times like 1973-74 and 2008-09 will always happen, as will the boom times. In early 2009, at the worst of the crisis, the S&P 500 Index at its absolute low reached the demonic level of 666 (volatility had peaked slightly earlier in November). Six years on it is over 2,000. Equating volatility with risk is near enough guaranteed to make you sell at the bottom.
Indeed sometimes the greatest risk is that investors are not exposed to enough risk: that is, the return of the portfolio will be insufficient to meet the portfolio’s long-term objectives. At an extreme, the paranoid saver who kept all her money under the mattress for the last thirty years would have seen the real value of her portfolio fall by around 65%: nominally the amount would be unchanged, but in terms of buying power, inflation has severely eroded its value. In terms of meeting investment objectives, a “low risk” portfolio can be hugely risky; holding a permanent cash portfolio is about as risky as they come.
Historical volatility is but one ingredient in a fiendishly complicated risk recipe. To understand the potential future risk of an investment requires a far broader field of vision and analysis. Is a business reliant on a small number of products or customers? Do the managers of the business have a track record? Does the business have a lot of debt? Can the profitability of a business be affected by a change in regulation? Are the profits and dividends of a company growing steadily or erratically? Is there sufficient market liquidity? Do the expected returns keep pace with inflation? Does the investment depend on the creditworthiness of someone else? How expensive is the company relative to its history and peer group? Does the industry face obsolescence?
The list above is just a small selection of the questions an investor should be asking. Whilst we know that the unexpected will always happen given enough time, only by looking at more heads of the hydra can we lessen the chances of being bitten by one.