Understanding investment risk

[Brendan Burgess]

Rory Gillen has a good article on his website about [broken link removed]

It's a good systematic treatment of the topic.

I was not aware that Benjamin Graham had desribed risk as the threat of a permanent loss of capital. That is an excellent definition as so many people think that volatility measures risk.

Volatility in the stock market is not be to feared. It is the nature of markets to be volatile. We must remember that volatility is not the same as risk. Trying to eliminate volatility while seeking equity-like returns, by buying guaranteed products or hedge (absolute return) funds, is fool’s gold. It does not exist.

For this insight alone, the article is worth reading.

Brendan

 

[Monksfield]

The point about not fearing volatility is fine in theory but,for the majority of people, not in practice.

I have seen first hand how lots of people whose pension contributions are tiny in the context of a working life building up a pension react after a tough year or two. Not at all unusual to see people switch into cash and stay there.

Research shows that people's attitude to gain and loss is asymetric (with losses hurting roughly twice as much as the pleasure of gain).
This is exacerbated in Ireland by the poor level of financial literacy. I think most people still complete the Leaving Cert barely having heard a mention of the stockmarket.

 

[Brendan Burgess]

The point about not fearing volatility is fine in theory but,for the majority of people, not in practice.

Hi Monksfield

It's very important when advising people to tell them what you believe to be right. It's important to tell them not to worry about volatility as much as the real risk.

Having said that, if they think that they might panic or lose sleep, then you have to factor that in.

 

[Marc]

Monksfield has hit the nail on the head here.

As a portfolio manager I am concerned about three risks in the equity market: size, book to market and systemic or market risk. In the bond market I am concerned about term and credit risks. I measure risk as volatility and i do this because for any given expected return, the portfolio with the lowest volatility will have the highest terminal value. These are all empirically demonstrated facts of investing.

But these are investment risks.

As a Financial Planner I am more concerned about real investors their fears and sometimes their greed which gets them into trouble. This is the asymmetric loss avoidance that Monksfield referenced.

We call the difference between the investment return and the investor's return the "behaviour gap" since it is mostly explained by investor's decisions to hold cash when markets are scary but to load up on tech stocks or bank shares when everything seems to be going well. This leads to a tendency to buy high and sell low.

Investors should try to focus on their goals and values and manage their taxes and exposure to risk, switch off the financial media and try to ignore the volatility. This is much easier with a professionaly drafted investment policy statement and by working with an adviser who can help you to remain disciplined and to stick to a plan and to ignore he sirens songs of stock picking and market timing.

As Warren Buffett says "investing is simple, but it isn't easy"

 

[Marc]

..

 

[tyoung]

Marc,
" i do this because the portfolio with the lowest volatility will have the highest terminal value."

Should this have been qualified by something like,
" for portfolios that have the same average return"

 

[Marc]

It should indeed, well spotted and thanks for the feedback.