One of the main things I talk to my clients about is their attitude to risk, after all it's an inherent part of investing.
There is no such thing as risk-free investing. There is no 'sure-thing', regardless of what anyone tells you.
I always make sure that my clients are fully aware of the risks associated with investing as part of my 'Investing Masterclass' session. Aside from the obvious market corrections that mean substantial losses, clients are often surprised to see how time out of the market, usually generated by fear, can also have an adverse affect on overall investment returns.
Everyone wants to protect their assets as much as possible so an understanding of how we process risk can help us determine why we make certain financial decisions.
Here's 4 ways that risk can impact your wealth.
#1 WE UNDERESTIMATE RISK
It’s one thing when we imagine risk and its potential impact on our lives and our investments. It’s quite another when it really happens.
In investing, underestimating risk can trick you into believing that you can tolerate far more of it than you actually can.
As financial columnist Chuck Jaffe has wryly observed: “[A] common mindset is ‘I can accept risks; I just don’t want to lose any money.’”
Unfortunately, we can’t have it both ways.
When the risk comes home to roost, if you panic and sell, it’s usually at a substantial loss.
If you manage to hold firm despite your doubts, you may be okay in the end, but it might inflict far more emotional distress than is necessary for achieving your financial goals. Who needs that?
#2 WE OVERESTIMATE RISK
On the flip side, we also see investors overestimate risk and its sibling, uncertainty.
We humans tend to be loss-averse (as first described by Nobel Laureate Daniel Kahneman and his colleague Amos Tversky), which means we’ll exaggerate and go well out of our way to avoid financial risk – even when it means sacrificing a greater likelihood for potential reward.
Whenever we hear about the latest global news be it Trump declaring war via Twitter, stalled Brexit talks or acts of terrorism, it's natural for us to think about what impact this could have on our investments. The truth is it doesn't really matter what is happening in the world.
We don’t mean to downplay the real influence world events can have on your personal and financial well-being. But the markets tend to price in the ebbs and flows of unfolding news far more quickly than you can trade on them with consistent profitability.
So it’s a problem if you overestimate the lasting impact that this form of risk is expected to have on your individual investments.
#3 WE MISUNDERSTAND RISK
Especially when coloured by our risk-averse, fight-or-flight instincts, it may seem important to react to current financial challenges by taking some sort of action – and fast.
Instead, once you’ve built a globally diversified, carefully allocated portfolio that reflects your personal goals and risk tolerances, you’re usually best off disregarding both the good and bad news that is unfolding in real time.
This makes more sense when you understand the role that investment risks play in helping or hindering your overall investment experience.
There are two, broadly different kinds of risks that investors face.
Avoidable Concentrated Risks: Concentrated risks are the kind we’ve been describing so far – the ones that wreak targeted havoc on particular stocks, bonds or sectors. In the science of investing, concentrated risks are considered avoidable. They still happen, but you can dramatically minimise their impact on your investments by diversifying your holdings widely and globally. That way, if some of your holdings are affected by a concentrated risk, you are much better positioned to offset the damage done with other, unaffected holdings.
Unavoidable Market Risks: At their highest level, market risks are those you face by investing in capital markets in any way, shape or form. If you stuff your cash in a safety deposit box, it will still be there the next time you visit it. (Its spending power may be eroded due to inflation, but that’s yet another kind of risk, for discussion on a different day). Invest in the market and, presto, you’re exposed to market-wide risk that cannot be “diversified away.”
#4 WE MISTREAT RISK
It’s a delicate balance – neither overestimating the impact of avoidable, concentrated risks nor underestimating the far-reaching market risks involved.
Either miscalculation can cause you to panic and sell out or sit out of the market, thus missing out on its long-term growth.
In contrast, those who stay invested when market risks are on the rise are better positioned to be compensated for their loyalty with higher expected returns.
In many ways, managing your investments is about managing the risks involved.
Properly employed, investment risk can be a powerful ally in your quest to build personal wealth. Position it as a foe, and it can become an equally powerful force against you.
Respect and manage return-generating market risks. Avoid responding to toxic, concentrated risks. These are the steps toward a healthy relationship with financial risks and rewards.
Achieving this healthy relationship with risk is not a one-time thing - you will be in the market for the long-term after all. So it's something that you'll need to address every time there is movement in the market.
Having a financial advisor and ally who you can call on in times of concern can really help you maintain a balanced view of risk and prevent you making emotionally charged decisions.