At PWA, we talk a lot about risk. It’s important. A foundational rule of investing is that risk and return are inextricably related. You cannot and should not expect to get great returns without taking risk. And because for most of us the whole reason we’re investing in the first place is to achieve a long-term goal we have, we need great returns to do that! That’s why it’s crucial for us to understand risk.
It’s no secret that 2020 has been a volatile year in the public investment markets. For most investors, risk has become reality in the form of actual losses experienced or the variance we’ve seen in our account balances. While times like these are uncomfortable to live through, they’re also a great opportunity for us to learn a lot about ourselves as investors. One lesson we might learn is that we are NOT comfortable with the volatility we see in our portfolio. On the other hand, we might learn that not only are we comfortable with it, we could take even more volatility.
Regardless of how we feel about it, now is the time for all types of investors to think about the risk we’re taking in our investments. We can do this by asking ourselves three questions:
- How much risk do I have? (Risk Posture)
- How much risk do I want? (Risk Appetite)
- How much risk do I need? (Risk Capacity)
Risk Posture: How much risk do I have?
In theory, this should be the easiest question to answer. Finding our risk posture is simply quantifying the actual risk that we are taking in our portfolio. In practice, however, it’s not uncommon for people to misunderstand this.
They may mistakenly believe that their entire portfolio is invested in “the market”, when in fact only a portion of it is subject to market risk, and other portions are invested in other things.
Or they may have what we call “the illusion of diversification”. This is when they believe their portfolio is diversified because it has many holdings. However, it’s quite possible—common, even—for those many holdings to have strong positive correlation. In other words, they may be different, but they act the same way. They rise and fall at the same time. That’s not true diversification.
Diversification is an important concept when trying to understand risk. One way to reduce the volatility of a portfolio is by owning investments that are not correlated to one another (i.e. “being diversified”). The goal is that when one investment falls, other parts of the portfolio will rise. So, if we want to understand our risk posture, we need to understand how diversified we are.
Risk Appetite: How much risk do I want?
Risk appetite, or risk tolerance, is what most investors think of when they think about risk. This is what is determined in advance of investing through use of risk questionnaires and conversations with an advisor, which are all attempts to answer the question, “How much risk can your stomach handle?”
While your risk appetite is initially determined at the start, it’s also important that it is continually confirmed or adjusted over the years through the lived experience of watching the balance of your portfolio fluctuate. Those times—times like this—are when you answer the question, “Am I right about my risk tolerance?”
Having more risk than you can stomach is a problem because eventually it will put you in danger of making an emotional decision at the wrong time.
Risk Capacity: How much risk do I need?
There are two sides to the risk capacity coin: How much risk must you take to accomplish your goals? And how much risk can you afford to take without jeopardizing your goals?
If, for example, you already have enough saved to meet your goal, you have a low risk capacity. In that case, your risk appetite and risk posture are likely greater than your risk capacity. You’re taking more risk in your portfolio than you need to. In other words, you’ve already won the game, you don’t need to keep playing. Or at least, you don’t need to keep playing so hard.
On the other hand, it’s also a possibility that accomplishing your goals will require more risk than you’d like to take or more risk than you currently are taking. If that’s the case, you have two options. Either you can adjust your goals to lower the target, or you can increase the risk in your portfolio to (hopefully) hit your target.
Figuring how much risk you need involves three variables: your goals, your time horizon, and your investable assets. Each of those variables is a lever that you can pull that will raise or lower the risk you need.
Understanding risk in investing is not a set-it-and-forget-it endeavor. It’s something that requires regularly revisiting past decisions and evaluating whether you need to make a change. Perhaps that change is reducing the risk of your portfolio because your stomach can’t handle it. Perhaps that change is saving a bit more each month so that you can meet your goals without taking on additional risk. Perhaps that change is adjusting the goals you’d previously set, lowering the target of what you’re aiming for.
Or, maybe there’s no change to make at all. But the exercise of evaluating risk—how much risk you have, how much risk you want, and how much risk you need—is worthwhile regardless.