Source: Pixabay. CC0.
Risk is the chance that something bad will happen. We don’t necessarily know how to define it, but we know it when we see it. We also know it when we feel it: that gut-wrenching sense of “Oh, no. Why can’t it just be five minutes ago?”
Several things go into measuring risk. The first is the question of how much. What is the size of the possible loss, relative to how much we have? When it comes to cars, I like buy used vehicles that are towards the end of their useful lives. I don’t usually carry collision insurance on them. They’re just not worth very much in the first place.
In finance, this is an issue of scale. As a general matter, we’re able to take more risk with a smaller stake.
Another element of risk is how we feel about losses. Some people never want to have problems. Maybe they grew up driving clunkers that were always breaking down. Maybe they just don’t like to be inconvenienced. For them, driving older cars can put them on an emotional roller coaster. It may be cheaper to buy and old car and fix it up, but the price of a potential breakdown isn’t worth the potential savings.
And it’s easy for me to talk about the risk of breaking down. I live in the boonies. If I have to leave a car on the side of the road, the biggest concern is that mice or squirrels will colonize the engine and start raising a family. Breaking down on the side of a busy highway, on the other hand, is no joke!
Photo: Srđan Popović. Source: Wikipedia. CC-BY-4.0.
Yet another aspect of risk is how bumpy of a ride we’re willing to put up with. Some cars don’t go very fast, but they provide a much smoother experience. On the other hand, some folks may like the thrill of the ups and downs. Not usually, though. Most would say that if we’re getting there at the same time, we’d rather not have to put up with all the disruption of a severely bumpy road, thank you very much.
Two different investments over the past 5 years. Source: Bloomberg.
But usually that’s not how it works. People put up with potholes in their investment path in the hopes that there will be more ups than downs. One of the most important aspect of different investments is how they pass through their underlying fundamentals. Short term government bonds aren’t very risky at all. Real estate carries more risk. Utility and healthcare stocks are a little more bumpy, and discretionary technology is the riskiest of all. This shows up in the volatility of their returns, and how they get their returns.
Different fund performance graphs. Source: Bloomberg.
Our risk tolerance measures how willing we are to put up with bumps along the road.
Finally, there’s the issue of velocity. Cars that seem perfectly safe at ordinary speeds can rattle around like a bucket of bolts if you get them up to highway speeds. There’s a reason why pictures of the high-speed German “Autobahn” system feature mostly new cars in good repair cruising along very smooth roadways. If you experience a deep pothole while zooming at the limit in a marginal vehicle, it won’t be pretty.
When we invest in the market, velocity plays a role in how risky it feels. The Dot-Com bear market played out very differently from the Global Financial Crisis, which was dramatically different from the Covid crisis. The Dot-Com bubble took almost 30 months to deflate; the GFC hit bottom after about half that time, and the Covid crash was over in a matter of weeks.
Index: S&P 500 month-end values. Source: Bloomberg, World Market Advisors.
The speed of the markets put stress on us in all kinds of different ways. We need to be sure that we have a good, healthy braking system before we accelerate down the speed-ramp.
Risk is part of investing. Volatility, losses, and speed bumps are the price we pay for growth. Assessing our ability to handle risk – our risk capacity, risk tolerance, aversion to losses, and our ability to slow down – can make all the difference.
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