Understanding “Risk” in Investment

In the world of investing and finance, risk means uncertainty from your investment decision. It does not mean loss, danger, threat, etc. It can be a potential loss if it’s not managed properly. So let’s go ahead with understanding the concept of risk in investment.

What does the dictionary say?

If you Google the meaning of ‘risk’, you’ll get the answer as:
“A situation involving exposure to danger.”
(or)
“Expose (someone or something valued) to danger, harm or loss.”

And then you hear ads saying:

“Mutual Funds are subjected to market risks.”

Or people saying, stocks are risky!
So what will a common man think about risk?
RISK!! Is it a DANGER? you start to wonder.

In my opinion, all these definitions are incomplete and pointless in the world of finance.

Here’s the answer.

Understanding Risk in Investment

Risk ≠ Danger
Risk ≠ Loss
Risk ≠ Thrill
Risk ≠ Volatility
Risk ≠ Opportunity

Risk = Uncertainty (When the outcome is unknown). Because if you know the outcome, you’d act accordingly.

For example, If you know a company is bad, it’s stock will definitely go down; you will not invest (you will instead short-sell). While giving a loan, if the banks know you will not repay, they won’t give the loan. There’s no question of risk, danger, or loss here.

However, if the banks give you the loan, then there’s uncertainty involved in future payments. Hence its called default risk.

After doing extensive research on a stock, you don’t know how markets will perform in the short-term, hence it’s called market risks (or systematic risk).

In reality, we take risks every day. By crossing the road, driving to work, we put ourselves in risky situations, & we’re not worried much. We’ve learned to manage them by following certain behavior. For example, looking before crossing the road or reducing speed while driving.

Similarly in investing, there are certain behaviors. For example, enough emergency funds, investing in good companies for the long-term—that has predictable cashflows, etc. Then the daily price fluctuations won’t matter. You’re unlikely to be forced to sell during that time. Instead, you might use that opportunity to buy more. Because for you, there’s high certainty of staying invested and earning profits. Higher the certainty; lower the risk.

Who’s taking the maximum risk?

If you only have a salary as income and some savings, and you take a long-term debt (for ex. home loan) which comprises a major portion of your expense. You have to pay the fixed (EMI) cost for 20-30 years whether you get the salary or not.

You are betting that you will definitely be able to make consistent EMI payments regardless of any future events, come what may. This sounds like a bigger risk to me because there’s nothing more uncertain than the future. Sadly, that’s what most people choose without understanding the risk in investment, finance, and managing money.

Most people think debt is good because it can magnify returns and save tax. But most of the successful managers have small debt in their companies and they have the potential to pay that debt anytime. This means they hold enough cash to pay off the debt completely if things go bad.

Day-traders are taking financial risks

Now think about this. Can you predict accurately whether the market will go up or down in the next 1 minute? In the next 1 hour? By end of the day? 1 month? 1 year?

The answer is no. (There is a 50% probability of getting it right, but nobody can say with 100% certainty). We like to do predictions, we enjoy it. We like to feel powerful. But in reality, despite several researches, nobody can be certain including any experts or economists.

However, the chance of accurate prediction keeps on increasing when you increase your time period. If you take a 5-year view, there are more chances that the market will recover & close in positive. If you think 10-15 years, it’ll surely be positive news.

On not taking risks

Not investing your savings properly is like working hard to start your business, hiring a lot of employees. Instead of getting them to work, you work all day and give them a long vacation. When you need their help after 40 years, they’re lazy and too weak to help. Who is at fault?

The real risk of inflation is not the fact that it’s increasing at such a high rate now; it’s the fact that it happens slowly & quietly, often ignored. Hence many don’t think of investing seriously which is a real risk in the long-term. So the people who aren’t investing in equities and taking small investment risks are taking the actual risk.

This is because inflation in the long-term is certain to happen and eat our purchasing power.

Most people consider fixed-deposit as good investments but they don’t even beat inflation. They surely give you the certainty of fixed interest income= less risk. However, no banks in the world will ever give you interest more than the inflation rate. What does this mean? In India, average inflation is about 7-8% and no banks offer interest rates more than this. So if you still think your interest is income, you’re fooling yourself.

What is danger, loss, volatility, opportunity, and the thrill?

Danger: is a possibility of something going wrong (only downside). But risk has both upside and downside potential.

Loss: it’s a downside outcome (usually when the risk is not managed effectively).

Volatility: it’s the fluctuations that happen in the stock market due to differences in opinion. It is helpful for a smart investor.

Opportunity: it’s just a possible action that can be taken.

Risking could be thrill in 2 situations, when you underestimate the loss, or when you can afford to lose it.

Conclusion

Instead of removing risk completely. Try to reduce it. Learn to manage it effectively.

Here are the key takeaways:

  • Don’t risk more than you can afford to lose.
  • When uncertainty is high, focus on risk before anything else.
  • Higher the uncertainty, higher the risk.
  • Look for opportunities where you risk less, get more rewards.
  • Increase your knowledge.
  • Research, know more, reduce uncertainty.
  • Prepare, reduce risk, Increase the reward.

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