Risk, Reward, and Reality: Demystifying Investment Risk
Let’s talk about risk…
Everything in life comes with a certain degree of risk. Whether it’s starting a new job, moving to a new country or even riding a bicycle. There’s always a chance that things won’t go as planned. This inherent uncertainty - this risk - is an integral part of life and the driving force behind change and more importantly growth. As Mark Manson (author of “The Subtle Art of Not Giving a F*ck”) says: Life comprises problems and challenges. Instead of trying to avoid them, find the ones you care about and thus wish to solve. The same goes for investing - risk is unavoidable. The idea is not to fear it but to be mindful of the ones that are worth taking, and their extent, in the pursuit of reward.
Embracing risk in investing doesn’t mean recklessly diving into dangerous waters
A “buy and hold” kind of investor who prefers a simple “basket” of a few chosen assets, like blue-chip stocks and corporate bonds, with the plan of holding onto them for years - if not decades, do so because they fundamentally believe in the strength of the assets. And this belief likely did not come out of thin air, but rather from their research on past performance, growth potential, and reputation of the issuing companies. They understand that investing comes with ups and downs. But they’re willing to weather it out because their investment decision is driven by their belief in the long-term potential of the chosen assets.
However, when investors place their capital into managed portfolios, they're entrusting professionals with the responsibility of diversifying their funds across various assets, which might include stocks, bonds, ETFs, and more. While managed portfolios are designed to optimise returns and distribute risk through diversification, it becomes imperative for investors to have a clear insight into the potential risks associated with a portfolio, so they can make informed decisions based on their risk profile and tolerance.
Risk tolerance refers to your comfort level with potential investment losses in pursuit of gains. It’s typically influenced by factors such as your financial goal, investment time horizon, and personal financial situation. But it’s equally important that you check your emotional ability; If seeing your investments go down in value keeps you up at night or makes you panic, you have a lower risk tolerance. Think of it as being someone who prefers calm, predictable rides over the wild roller coasters.
So how do we quantify risk beyond low, medium & high?
There are various ways, but one of the most widely used methods since the late 20th century is Value-at-Risk (VaR). It became popular in the ‘90s, when financial institutions adopted it to quantify their exposure to market risks. Today, VaR is an integral part of risk management practices around the world.
It’s a statistical approach to assessing risk that involves analysing historical price trends and volatilities of the investments in a portfolio, and applying statistical methods to provide a worst-case loss under normal market conditions. VaR quantifies the worst-case loss that could occur in an investment over a specific period with a given confidence level.
For example, a daily VaR of $100,000 at the 95% confidence level implies that there is a 5% chance that the portfolio's loss will exceed $100,000 over a one-day period. At StashAway we combine several applications of the VaR metric, both statistical and scenario shocks which ensures a more robust measure, to give you the StashAway Risk Index. We use 99%-VaR, which means a portfolio has a 99% confidence level or probability of not losing more than a given percentage in a year. So with a $100,000 example, a StashAway Risk Index of 20% has a 99% chance of not losing more than 20%, or $20,000 in a year.
VaR is an extremely useful tool for understanding potential risk, but it's important to remember that rare and extreme events can occur.
Understanding investing risk isn't just about recognising potential losses—it's about making informed decisions, identifying opportunities, and, above all, ensuring that the level of risk you as an investor take aligns with your financial goals and risk tolerance. Knowing your risk tolerance helps you select investments that align with your comfort level. Because after all, investments don’t simply follow a straight upward trajectory. Investing comes with fluctuations that are not roadblocks on your financial journey - but an integral part of it.
This is where a metric like Value-at-Risk (VaR) becomes an invaluable tool in an investor’s toolkit. It’s a simple and easy-to-understand measure that helps you make informed and appropriate investment decisions; that ensures you can withstand and remain comfortable with the level of risk in your portfolio, preventing scenarios where market downturns drive hasty decisions that could potentially hurt long-term financial goals.