When most of us evaluate an investment opportunity such as a stock, bond or mutual fund, we first pay attention to the investment’s return. We tend to ignore or discount the relationship between an investment’s risk and return because the investment’s performance is all we really care about in the end.
In reality, the risk of an investment is just as, if not more, important than its investment returns, and managing that risk component is imperative to achieving long-term investment results.
This concept can be illustrated by taking an extreme example. Suppose U.S. Treasury bills are paying 5 percent while wheat futures in North Korea are currently paying 6 percent. Obviously, there is a tremendous disparity in the risk between these two investments, and it would be wise to consider taking a small reduction in potential investment return to substantially reduce the risk of your invested dollars.
That is not to say that risk is a bad thing. Avoiding risk altogether is impossible, and slanting your investment portfolio completely away from risk will make it very difficult to achieve growth and meet your long-term financial goals. Consider how much more you would need to save for your retirement if you only used your savings account!
Therefore, we need to manage and control the relationship between the risk and return of our investments. Another way of looking at that is demanding that you as an investor are adequately compensated for the risk you are willing to take in your investment portfolio.
Risk has many different forms, but all investment risks can be broken down into two categories: systematic and unsystematic risk.
Systematic risk is based on larger macroeconomic forces that cannot be diversified away. Those include changes in the global economy such as inflation, interest rate fluctuations and military or political turmoil, to name just a few. All investments are susceptible to systematic risk in some way.
Unsystematic risk on the other hand is unique to each investment, and therefore it can be diminished through proper diversification. If all of your investment dollars are concentrated in a single company, then your returns will be greatly affected by issues such as changes in that company’s management structure and the emergence of new technologies from rival companies.
Unsystematic risk is also impactful at an industry-wide level. For example, changes in health care legislation would affect all health care related businesses. That risk could be lessened by including other industry sectors such as financial or agricultural areas that wouldn’t be influenced by the same factors.
This highlights the need to maintain a well-diversified portfolio and avoid concentrating your investment dollars in any one company or industry sector. Ideally, you would want to hedge the risk of your investments so that when one area underperforms, a competing area will outperform, and your overall investment portfolio will continue to steadily grow.
A prudent investor needs to maintain objectivity when constructing a portfolio and avoid biases such as company and industry preference or overvaluing recency.
Recency is a behavioral finance concept that places more meaning on recent events over past historical data. When markets are booming, we feel like there is less risk, and we want to invest more. When there is a market correction, we feel like our dollars are more at risk, and we want to withdraw to avoid losses. Oftentimes, the exact opposite is what we should be doing.
I encourage you to take some time to consider all the various risks of your current investment portfolio and if some of those risks can be lessened through diversification. Managing and controlling these risks will show up in the long run with improved investment returns.