How Do You Measure Investment Risk?

There are a lot of sophisticated measures in the investment business: P/E Ratios, Cash Flow Analysis, EBITDA, etc. The list goes on and on (and on). The one I find most interesting, however, is how most people measure risk. The generally agreed upon method is to measure volatility, which is how much the price of a particular asset (stock, bond, whatever) goes up and down, often in conjunction with looking at expected return of the particular asset. To simplify it a bit, the more the price of something changes, the riskier it is.

I find that fascinating and mostly wrong. If you are a long-term investor armed with self-control, measuring risk by measuring volatility is not very useful. This analogy is a bit of a stretch, but I’ll use temperature as an example. If a particular day starts at 60 degrees Fahrenheit and goes up to 80 then back down to 60, that would be considered “worse weather” than a day that starts at 100 degrees and stays there (or 40 degrees and stays there).

Now, if you are an investor who is actively trading, constantly moving in and out of different positions, volatility is important. Likewise, if you are an investor that is going to need to take money out of a particular investment in the near future, volatility could be important. But I prefer a different measure of risk: how likely are you to meet your goals?

To me, this is really the only measure of risk that matters. Will your investment portfolio/strategy achieve the goals you have set for it? If you are a long-term investor (and if you end up working with me you will be :-), you don’t care all that much about the daily ups and downs of your investment, as long as at the “end” your investment is up a sufficient amount that allows you to achieve your goal. Which means that if you construct your portfolio correctly, there is really only one sub-component of that risk that matters: you.

More specifically, do you have the self-control, the discipline, to follow your investment plan? When bad things happen (like the Great Recession in 2008, or the dot-com bubble in the early 2000’s, and the value of your investments drop, sometimes by a lot), will you be able to stay the course and not bail on your plans? One of the main reasons to hire a real financial planner (or even avail yourself of my services), is that they hopefully will help you to stick to the plan. While there are no guarantees, based on the entire history and theory of financial markets, if you invest for the long-term and don’t sabotage yourself by abandoning your investment plan at the worst possible times, you are (almost) guaranteed to be successful.

In fact, there is plenty of research that most investors earn less (often far less) than the mutual funds and other investments they invest in earn. How can that be? They buy high and sell low. They typically buy into a mutual fund (or stock, or whatever) after if has performed really well for a while (missing out on most of the gain), then lose heart and sell when it inevitably goes down. It’s the investor’s behavior that causes them to under-perform, and hence the riskiest part of investing isn’t typically what you choose to invest in, it’s you.

So what’s the secret?

1. Spend less than you make.
2. Regularly invest the difference in low-cost index funds.
3. Don’t sell (unless you’ve achieved your long-term goal).

I’ll write several more posts exploring different aspects of this, but it pretty much is that simple. That’s one of the most frustrating aspects when I hear others talk about their finances. Either they are too afraid of “investing” because they are worried about losing their money (or somebody taking advantage of them), or they are constantly moving from investment to investment to try to outperform the market (generally with poor results, as that study indicated).

As I mentioned in one of the FAQs, about 90% of what you need to do is really pretty straightforward, and not all that hard to do, if you simply know a little bit and have that self-discipline. I’d be happy to get you started on that path.

Photo credit: Foter.com