Investors usually define risk as the volatility of any particular investment. Because the value of stocks fluctuates, they are considered “riskier” than other types of investments, such as bonds, CDs, or Treasury bills. The problem is that the volatility of an investment is not the only metric that determines risk.
Risk is Absolute Loss of Capital
To start, investors need to remember that real risk is about the absolute loss of capital. Money invested in a stable asset may not experience the risk of volatility, but it may still lose value over time because of the cost of inflation. We tend to overlook this kind of risk because inflation is a more hidden cost compared to market volatility. You can see the value of your investments going down when the market experiences a correction, whereas inflation simply takes away buying power over time.
This means that stashing all of your nest egg in a conservative investment could potentially be riskier than investing in more volatile assets. The dollar amount of your portfolio may not ever go down with conservative investments, but your buying power will. Understanding this potential risk is an important part of ensuring you have a balanced investment strategy.
Your Personal Risk Factors
Another factor that many investors don’t take into account in their own personal risk factors. While you may have taken a risk tolerance questionnairei, that does not mean you know the idiosyncratic risks you personally face.
For instance, if you are a nervous investor who is ready to pull out of the market at every dip, your absolute risk (defined as loss of capital) is different than that of the investor who chases returns from one investment to the next.
If you are a Chicken Little type who fears loss of your principal, you risk the bite of inflation because you may invest in enough volatile assets to see growth. But if you are more of a speculative investor, you risk having too much money invested in volatile assets and potentially losing principal.
Risk is Not the Same as Risk Tolerance
Whether you are a nervous or an exuberant investor, your absolute risk stems from your psychological makeup. This means that while a risk tolerance questionnaire may help you understand how much volatility you feel comfortable seeing in your portfolio, it will not tell you the ways you are most likely to risk losing capital.
For the majority of investors who score solidly in the middle of the road on their risk tolerance questionnaires, creating an asset allocation based upon their risk tolerance can create a reasonably balanced portfolio. But investors who are either highly fearful or highly speculative will see higher risk of the loss of their capital even if they are allocating assetsii within their risk tolerance.
Knowing how you are at risk of losing capital can help you better craft an investment strategy that could help you achieve your goals. And understanding your personal risk factors can help you make good decisions for your money. After all, your personal finance is all about you!
i Risk tolerance is an investor’s general ability to withstand risk inherent in investing. The risk tolerance questionnaire is designed to determine your risk tolerance and is judged based on three factors: time horizon, long-term goals and expectations, and short-term risk attitudes. The adviser uses their own experience and subjective evaluation of your answers to help determine your risk tolerance. There is no guarantee that the risk assessment questionnaire will accurately assess your tolerance to risk. In addition, although the advisor may have directly or indirectly used the results of this questionnaire to determine a suggested asset allocation, there is no guarantee that the asset mix appropriately reflects your ability to withstand investment risk.
ii Asset Allocation does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.