When people think about investments they tend to think in terms of returns. That’s natural really. We’re ultimately putting our money to work to get something extra back in return at a time in the future.
The problem with focusing purely on returns is that you’re missing an important part of the equation: risk.
As legendary investor Benjamin Graham once suggested, the essence of asset management is risk management, not the management of returns. We can’t know with any confidence what the returns will be on any conventional investment (and even those with guaranteed returns have their own risks) but we can gauge risk with a fair bit of accuracy.
So whenever you’re looking to buy an investment, whether that’s shares in Apple or an amazing investment property, you need to understand risk and what your attitude is to it. Mastering your personal finance requires you to get a better sense of what risk is right for you. Are you taking on risk in buying this investment that isn’t suitable for you?
Mastering your personal finance requires you to get a better sense of what risk is right for you. Are you taking on risk in buying this investment that isn’t suitable for you?
In theory, every new investment you make has to be viewed in the context of what you already have. The idea is that by adding that great stock, that brilliant mutual fund or that spectacular art investment to what you already have, you are setting out to lower the portfolio’s risk, raise its returns or do both.
Understanding Risk and Returns
That’s the principle of portfolio theory anyway. We’ll leave the complexities of the theory for another time but, let’s be honest, very few of us will naturally think in this way.
Yes, your investment advisor will get you to fill out a risk profile questionnaire, which provides a framework for what they should and shouldn’t be putting you into, but few of us naturally manage our lives in that way.
What the principle really says is that not every financial gain should be viewed as a victory, nor every loss a disaster. It’s about context. You see, sometimes we find ourselves taking on more risk than we should in order to make that gain. It’s really about whether the risk is worth taking for what you get in return, or what’s known as the “risk-weighted return”.
Suppose someone said they would pay you $1 million if you entered and completed a marathon? You may be out of shape, the training would be tough, and you may have hated running all your life, but you may think that’s an offer worth taking up.
If you fail to finish all you’ll be left with (hopefully) are blisters and sores in all the wrong places, a bruised ego and a lot of disappointment. But when you sign on the dotted line in advance you may see that downside as manageable.
Now, suppose you were offered the same amount of money to tightrope walk across the Grand Canyon? That’s a very different story.
What if they offered you $10 million to do the feat? Maybe no monetary figure could ever interest you, given the downside risk (i.e. falling with such a spectacular view). But maybe you’re daredevil Nik Wallenda and the offer might be very interesting indeed.
The Dangers of Generic Information
This is why generic investment tips you may see on TV or in your Sunday newspaper can be dangerous. Not everyone watching that same TV show will have the same willingness and ability to take risk. You could be a 30-year old struggling single parent, a 45-year old successful entrepreneur or a 70-year old retiree comfortable in her life.
You’re likely going to be looking at your finances from entirely different positions. In other words, don’t assume that every investment idea or tip is right for you. They simply can’t be.
So when you next get a “hot stock tip” from your cab driver, have a think about the risk. If your investment portfolio is stuffed full of these kinds of ideas then take a look at it all. Importantly, are you able to sleep well at night? Don’t get seduced by the promise of instant wealth. Returns like that come at a price, and it might not be a price that you should be taking.