Written by: Jason Lawit | Northern Trust
The recent bout of capital market volatility is a good chance to revisit a fundamental component of capital markets and investing – risk.
In some scenarios, risk seems intuitive and easy to understand. In climbing, it seems pretty clear that free solo climbing (climbing without any aid) is riskier than aided climbing. Risk in this context is great injury or death.
There is no simple explanation of risk in investing.
And, risk can mean different things to different investors. Risk can mean failure to achieve a goal, volatility or complete loss. My suggestion is that considering what risk means to you is a critical component in driving to a sound investment plan.
To be a successful investor, it is also important to consider investment return’s relationship risk. The graph above is representative of a relationship between risk and return at a basic level. As risk increases (along the x axis) – according to the graph – so does return (along the y axis) – resulting in an upward sloping line showing a strong relationship between risk and return. The logic represented in the graph is:
- People are rational;
- Given two otherwise equal investment opportunities, a rational person would choose the investment with less risk;
- So, to compensate an investor for a riskier investment, more return is demanded; and
- Accordingly, as risk increases so do return and therefore risk and return are related.
For me, these concepts and this graph are critical to being a sound investor.
Investing is a discipline which, at times, can seem to be subject to easy quantification. You can look at a portfolio and determine its historical return as well as host of other quantitative measurements. You can also run models for a multitude of forward looking analysis. Notwithstanding the potential comfort of a third party’s complex analysis, do not skip the opportunity to engage in a personal understanding of important, foundation concepts critical to being a long term successful investor:
- What does risk mean to me?
- Do I have an understanding of return’s relationship to risk?
So perhaps this market isn’t scary at all …
… maybe it’s the same market with a modestly lower price point today and a higher expected return.
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