In the current volatile market environment, emotions can sometimes get the best of investors and cause them to abandon their long-term investment plans. I want to discuss the concept of risk, and what it means to you and your investment portfolio.
Let’s define risk, so that we understand what we’re talking about. Most people would describe risk as something negative. Webster’s definition for risk is “the possibility of loss or injury”. This sounds pretty bad. Most people think risk needs to be avoided when it comes to investing.
But this is only half of the story. Without risk there is no way to make money. Let me explain. A better definition of risk is “the uncertainty of expected returns”.
Consider two investments: a 10 year certificate of deposit, paying annual interest of 3.5%; and an investment in the SPY, an exchange traded fund representing the return of the S&P 500 index. Both of these investments have an expected return. The expected return of the CD is 3.5% annually, with the full return of principal at maturity. Assuming that the bank that issued the certificate is still in business in 10 years, the return is certain. Therefore there is no uncertainty. Therefore this investment can be said to have no risk. For amounts of money under a certain threshold, there’s an extra layer of protection in the form of FDIC government insurance. The point is that we can consider this investment risk free.
The investment in the SPY also has an expected return. We can look back over numerous periods in history and see that the average 10-year period produces somewhere around a 10% annualized return. If we look at any given year, however, the return can vary greatly. The actual return in a given year could be a lot higher than 10%, or it could be a lot lower than 10%. This is “uncertainty of expected returns”, or risk.
Here’s the interesting thing about this analysis: risk works both ways. Risk not only is the possibility of loss or injury, which would entail having a terrible year and a portfolio down double digits. Risk also is responsible for those years where the portfolio is up 30+ %.
The essence of investing, and what I want you to understand, is that you can’t have one without the other. Risk is the element that gives you those great years where you make a lot of money. Risk is also the element that gives you those sleepless nights, hoping your portfolio doesn’t crash.
The most important job of an investor is to take the proper amount of risk for their particular situation. If an investing friend brags about his huge returns, that’s great, but he may be willing to assume much more risk than you. Remember, risk means uncertainty.
Many investors have the idea that there is knowledge out there that can help one know when to get in and when to get out. This is what we call market timing, and it simply does not work. For every successful decision that works out great, there is also the decision that results in catastrophe.
The key to successful investing is designing a portfolio that has the proper amount of risk for you. At Terrapin Capital, all of our clients complete a very rigorous risk tolerance questionnaire before we invest their money. Why is this so important? Taking the proper amount of risk in your portfolio is the most important factor in your success as an investor. If a portfolio is designed for you with the proper amount of risk, you can relax when the market is down hundreds of points, because you know your investments are doing exactly what they are designed to do.
If you’d like to discuss your personal situation, please give us a call. Click here to download our risk tolerance questionnaire.
