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What’s a risky investment? Most people think an asset that swings wildly in price is very risky.
But in fact, that is volatility and not risk. A volatile investment is risky only if you may have to sell it during one of its downswings.
So, we can define risk as really the relatively certain chance of a loss. For example, think back a short six years ago. My (and possibly your) portfolio dropped in “value” over 30% in late 2008 and early 2009. But by doing nothing but waiting, it is now much larger than in 2008. By not having to sell, we were not clearly exposed to risk at the time. This is crucial to understand if you invest in volatile investments like stocks.
Hedge fund leader Howard Marks recently remarked that he deeply believes that we cannot predict the future with enough accuracy to either clearly benefit from or avoid risk. He thinks that we can instead develop a range of possibilities of future events and invest based on these assumptions.
Marks also develops a very interesting theory on the relationship between “risky” investments and returns. He notes that if riskier investments generally had better long-term returns, they really would not be risky. Instead, he makes the point that “riskier” investments have a higher chance of both better and worse returns over time than do “safe” investments.
He also reminds us that there is a risk in not taking enough risk. Staying in money market funds long term is less risky than the stock market but has a high opportunity cost. He points out that the behavior many investors use to “reduce risk” instead adds the risk of “missing out.”
Perhaps the only real risk we can ascertain at any time is that of overvaluation. This valuation would need to be extreme, yet there are recent examples. In 2002 and 2009, stock valuations were very low, and a prudent investment would pay off. Conversely, in 1999 stocks were overvalued. In 2006 and 2007, real estate in many parts of the country was overvalued (remember the lines of people waiting to pay full price for condos?).
However, most of the time, and with most assets, the valuation is more vague. For example, in 2007, stocks were not really overvalued but reacted to a liquidity crisis tied to the mortgage market. During these times we need to be diversified, patient and disciplined, and we must continually assess the many possible risks on the horizon. We also need to remember that large price swings are factors in risk. An asset that has markedly dropped in price has less risk, not more, and vice versa.