How do I know how much risk I’m taking with my investments?
Investment managers always like to talk about risk.
“This investment is too risky.”
“I’m not sure you’re taking enough risk to get where you want to go.”
“Let’s play Risk.”
We can have soft, meaningless conversations about risk all day that don’t do us any good. Or we can have meaningful ones where we actually figure out what risk is, how it affects our portfolio, how it meshes or doesn’t mesh with our timeframe for needing access to our money, and then make an informed decision.
So let’s start by defining risk. According to Merriam-Webster, risk is defined as “[the] possibility of loss or injury.” In most cases, people aren’t breaking legs or pulling muscles while investing, so I think we can push the “injury” piece off to the side for now (though I reserve the right to revisit this in the future). It’s the “possibility of loss” portion of the definition that’s most relevant as we talk about risk. With investment risk, the key is not only acknowledging the possibility of loss, but also assigning a probability of loss. We’re trying to measure what the odds are that you lose a portion of your investment’s value.
Risk exists in a ton of different forms – it’s even present in things you think are safe. Take bank accounts, for example. They’re FDIC-insured, meaning that the United States government will step in and pay you the amount held in your bank account (up to $250,000 per depositor, per bank) in the unlikely event that your bank goes out of business. So most people look at that and say confidently, “The money in the bank has no risk.” Oh, but it does. It doesn’t have market risk, the risk that your asset may lose all of its value because market participants decide your investment is worthless. But money held in bank accounts does have significant inflation risk – the risk that prices continue to go up and your bank account doesn’t earn enough to cover those increases.
Inflation risk is one type of risk. Market risk is another. We could go through all the different types of risk out there – interest-rate risk, counterparty risk, liquidity risk, and so on down the line. That would be way more than we could possible write in a quick, easy-to-understand article, so we’re going to get to those eventually and cover them in detail. But we’re not going to do it here. And we’re not going to answer the question of how much risk exists in your portfolio. Today, the goal is to get you thinking about the types of risk that you may not have thought about previously.
Sure, you can have an asset allocation that is lighter in stocks, but will that portfolio keep up with inflation well enough if you want to retire early? And yes, you can buy a higher percentage in equities if you’d like. But how do you factor in timing risk, or the chance that you might miss out on beneficial movements in the price of a stock you own, because you’re forced to sell it on a dip to meet your cash needs? You are always taking a risk with every investment you make, even if that investment is cash. The goal of a strong portfolio allocator isn’t to eliminate risk. It’s to balance the risk you are taking with the goals for your portfolio. It’s about figuring out the probabilities of how and when you need to access the money in your portfolio, and then looking at the probabilities of things that could derail your ability to do so.
Are you concerned about inflation?
If so, you might want to look at building in some additional equity exposure. Now, does that equity exposure have you worried about a market dip? Let’s cut spending a bit to build more of a cash flow cushion so we can take that risk. Are you nervous that your job might be cut and that cash flow won’t be there? Start some online classes or grab a part-time job. Investments are only part of the solution to your financial picture. Sometimes we have to look outside them to solve the risks present in them, or at least mitigate them through behavior rather than changing the investment.
So let’s circle back to the original question – how do you know how much risk you’re taking in your investments? It’s not as simple as saying, “I’m 60% in stocks so I could lose all of that.” That statement is true, but it’s not the total picture. The total picture requires a different question that you need to ask yourself. The question isn’t about understanding how much risk you’re taking since that question only gets you part of the answer, as we just saw. The real question that you should be asking, is, “What risks am I taking with my investments, and are they the right risks for me to be taking?” That’s going to get you moving in the right direction with your thinking.