Understanding Investment Risk

A critical component of creating a successful investment portfolio is risk management. There are many different definitions of risk when it comes to investing (portfolio fluctuations, drawdowns, etc). However, risk can simply be defined as any uncertainty with respect to your investments that has the potential to negatively affect your financial well-being.

Though most people like to focus on the returns of a portfolio as this is the “more exciting” piece of investing, returns alone don’t paint a clear picture. It’s crucial to think of returns in relation with risk. We need to consider the amount of risk being taken to achieve a certain level of returns in order to have a better understanding of how a portfolio has actually performed.

Risk has been misrepresented as something that should be completely avoided. While managing risk is important, risk can be classified as a necessary evil for many investors. Risk and returns go hand-in-hand. The greater long-term returns you want to achieve, the more risk you’ll need to bear. 

There are two main categories of risk:

Unsystematic risk is classified as individual, non-market risk. This is the type of risk that is diversifiable and avoidable. Some common examples of non-systematic risk include:

• Business Risk – The risk that a specific business will experience a downturn or fail.  
• Liquidity Risk – The risk of not being able to easily convert an investment to cash without negatively impacting the price.
• Political Risk – The risk of all investments in a specific country or region if policies or laws are changed.

Simply increasing the number of different investments within a portfolio is going to help diversify away unsystematic risks. There is no exact number for the amount of individual investments to use, but studies have been done that show once you get to about 20-30 different holdings the benefits of diversification begin to show diminishing results.

Systematic risk is classified as market risk. This type of risk is not diversifiable. You cannot avoid the risk of the market unless you choose to not invest in the market. Common examples of systematic risk include:

• Purchasing Power Risk – The risk that your money will not be worth as much in the future because the return on your investments will not keep up with inflation. 
• Interest Rate Risk – The risk that interest rate changes will change the value of your investments.
• Recession Risk – The risk that an economy will slow down and negatively impact asset prices.

It is important to remember that risk is not always a bad thing to have in a portfolio. Risk does not always need to be avoided; having some level of higher risk can increase long-term returns. For example, stocks are generally considered more risky than bonds, but offer a higher expected return over the long-run in exchange for the added risk and uncertainty.

The most important thing is to determine your tolerance for risk and build a portfolio that uses the appropriate amount of risk for you in the most efficient manner possible.

Derek Prusa, CFA, CFP® and Ben Webster, CFP®

Co-Founders and Owners of Aspire Wealth