More on Risk - The Wiggle
In my last article, we spent time thinking about risk and how it feels. Through a few thought exercises, we were able to capture the different emotions risk can evoke. Fear, excitement, regret, and instability all play a part. They combine to form the two most common feelings associated with risk: risk tolerance and loss aversion. If you haven’t yet, I encourage you to go back and read about the very real emotional toll risk can take.
But now I would like to think about risk in a more practical way. There’s no thought experiment needed here; this will be more about the actual characteristics of risk and how it plays a critical part in our investments.
Risk in finance
I want to challenge the way you think about risk. Take a second and consider what risk means to you. Not the feeling side of risk, but the actual meaning of the word.
If the idea of loss comes to mind, then you’re off to a good start. After all, the association of risk and loss is timeless. For instance, when we wish to avoid risk, we take measures to prevent loss. We buy insurance. We behave in safer ways. We don’t take unnecessary chances in the hopes of preventing undesirable outcomes (loss).
However, there are times when we choose to embrace risk. Gambling, for instance, provides us with an exhilarating way to accept enhanced risks for the chance of outsized gains. Similarly, in the world of finance, the idea of inflated risk in pursuit of exponential gains has another name: speculation.
Volatility
While speculation has a place in finance, you don’t need to participate in speculative investments in order to experience risk. It isn’t rare. In fact, outside of short-term treasury bills and FDIC insured accounts, risk is ubiquitous. It is a part of nearly every investment.
It is important to note the difference between the risk associated with gambling/speculation and the risk inherent in nearly every investment. As we discussed before, gambling affords us the real chance of loss; total loss. However, when we talk about risk in investments, we’re not only talking about the chance for total loss. What we’re really talking about is volatility.
The graph
Indulge me for a moment and imagine a line graph. Yes, the line graphs you used in high school. An x-axis, a y-axis, and a line representing some function or formula. For our purposes, think of this line graph in terms of time and money. Now, up in the positive quadrant somewhere, we’re going to place your goal. This goal is an amount of money needed (y-axis) at some point in the future (x-axis). It looks like this:
In order to achieve this goal we need some return on our investment. We need to either invest enough money over time, achieve some return, or some combination of the two. In a perfect world, achieving our goal would look like this:
The wiggle
But it doesn’t actually look like that. It never does. Outside of the risk-free options I mentioned before, we must accept some level of risk. Remember, though, we don’t need to accept total loss as risk (even though it technically is a possibility). As mentioned, for investments we use the term volatility. For our visual examples, I like to use the term “wiggle”. This is because when we visualize volatility, the actual return wiggles above and below our desired growth line:
For a low level of return, the “wiggle” is present, but it isn’t much. This small wiggle represents the low level of volatility we are willing to accept for a low level of return. It makes sense, too. If we invest in something that we don’t expect to grow much over time, we would also expect it to grow in a very steady fashion. If there was more volatility associated with a low return, would it be worth the investment? Probably not.
Increased return, increased wiggle
But what if we hoped for a higher return on our investment? You guessed it, we need to accept more volatility, more wiggle.
Again consider the image above. Now imagine we can physically grab the “goal” end of the line. If we grab that end of the line and push it up, the wiggle comes along for the ride. And, as you might expect, something happens to the wiggle along the way. As the return increases, so does volatility.
If we expected a low level of volatility for a low level of return, then we need to accept a higher level of wiggle as our expected return increases.
Even more return, even more wiggle
If we once again grab the “return” end of the line and push up even further, the wiggle keeps increasing. That is, the volatility expands, making the path to your goal less linear and less predictable.
Now that’s one hell of a ride. Despite this crazy up and down, remember time is (hopefully) on your side. The hope is, over time the volatility evens out and you end up close to your goal.
Risk is a part of the puzzle
As we’ve seen, risk is an unavoidable part of investing. Along the way we experience this risk as our investments surge and swoon, providing for both an exciting and stressful experience. The good news is, by keeping your values at the heart of your plan, forming goals around your values, and minimizing risk through index funds, you can embrace the volatility as the proper balance to the growth you pursue. Don’t be afraid of the wiggle along the way.
Next time at Everman, we talk about the specific difference between volatility and risk. Specifically, when volatility turns into risk.
