Risk

Understanding Risk

In a perfect investment scenario we would all want to find “safe investments”, which would produce amazing returns without the possibility of losing any money. The reality is that there is always a form of risk. (Even if someone were to keep their money in their mattress literally, I would suggest that this money’s value would be exposed to erosion from inflation). The two basic questions to address surrounding risk are; am I comfortable with that amount of risk liability (this type of risk exposure) and can I do anything to mitigate my risk exposure?  

Diversification

Mitigate Some Risk by Diversification

One approach to mitigate risk by diversifying is by using Index Funds. (please note: one can be diversified in many ways. Not only by using index funds.)

When one is invested in a  stock index funds within a diversified portfolio, one can rationalize a dramatic point that it would be improbably to suffer a complete loss of this investment because in order for that to happen thousands of major companies throughout the world would need to fail simultaneously. Since the odds of this occurring is not likely, this investment may be considered safer than being invested in one company’s stock. (I did come across someone a few years ago that has their entire nest egg in one stock, their company’s stock. The problem is that if this stock were to come into hard times, this person’s entire life saving would go down too. wow!)

 Volatility

How to Handle Volatility?

When an individual does not understand the market, emotions can cause an abrupt exit. An understanding of the market, and the very nature of the investments is critical especially when the markets fluctuate, showing ups and down known as volatility.

According to Yale University Professor Roger Ibbotson this is how one should handle volatility; “for the most part, the individual should ride through these things, buy and hold. If they do react, usually what's happening is that their emotions work against them. They're looking backward. They get scared and they're driven away from the more rational behavior, which is to just settle down.”

Expectations

The Expectations of Investments

No one has a crystal ball that can predict the future, that is why a responsible financial educator or professional must include a statement similar to “past performance or returns is not indicative of future results” on publications and marketing material because it would be misleading to present returns from the past to the public. They may assume that this is what the financial professional can also do for them  or misrepresent a message of how they “will” perform tomorrow, next month and next year.

There are some individuals that try to time the market (like day traders- professionals and hobbyists)  or use technical analysis such as charts to notice patterns and trends, I don’t believe the average or even sophisticated investors should approach the stock market like this.

This is largely because  I am from the school of thought that believes in the value of understanding the Efficient Market Hypothesis:

“The efficient market hypothesis (EMH), created in the 1970s by Eugene Fama, is an investment theory that states it is impossible to “beat the market,” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing. It states that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.” Investopedia

What’s interesting is that the naysayer aren’t claiming the EMH to be wrong outright but instead many explain their anti-position by stating the exceptions such as the 1987 stock market crash when the market went down by 20%. My take on this is that anomalies, exceptions and even “black swans” may happen – and yes some risk seekers such as hedge fund managers wait for these opportunities when the norm is very much off kilter in order to ‘take-advantage’ of the temporary mispriced parts of the market. But at the end of the day the anomalies, exceptions and “black swans” are merely the exceptions and not the norm, therefore I am of the belief that most investors should adhere to the Efficient Market Hypothesis.

What Does This Point of EMH Mean for the Investor?

For one thing, don’t try to time the market. The investor should think about the market as an opportunity to invest in a business as opposed to a game of chance, which means if you decide to become an investor yous should understand that there may be up years and there may be down years. But overall, a well diversified portfolio over time, should have a positive return. According to Good Financial Cents founder Jeff Rose,   the average stock market return is somewhere between 7%-10% (depending on the parameters being considered). For example, he shows that from 1928-2014 the S&P 500 returns were approximately 10%. Also master investor Warren Buffet made a point to tell Lebron James publicly that  “Just making monthly investments in a low-cost index fund makes a lot of sense,” He added: “Owning a piece of America, a diversified piece, bought over time, held for 30 or 40 years, it’s bound to do well. The income will go up over the years, and there’s really nothing to worry about.”   

In Closing

Learn to become a better investor by asking questions because you should understand your investments, and be comfortable with the type of risk exposure you have. When in doubt, put pen to paper and write out a plan which may include goals and dreams (this could be a one page directive), and try stay the course, and be mindful of your investment expectations and in the end you will hopefully be better off.