Now financial folks aren't stupid (no, really); we're just using a different definition for risk. We talk about downside risk, too (the chance of getting your head taken off). We're not oblivious to the intuitive notion of what risk is. So when someone starts talking about risk, make sure you know what definition is being used.
Here are a few definitions of risk that may help as you wade through financial news:
Benchmark risk - the chance that your portfolio will give different returns than the benchmark (whatever you measure returns against). The more difference there is between your portfolio and the benchmark, the more likely you have benchmark risk. For example, if your benchmark is the US market, but you're invested primarily in European stocks, you have a lot of benchmark risk. In fact, you're probably using the wrong benchmark.
Market risk - the risk that you take on when you invest in a diversified portfolio of stocks. You can't do much about this. If you want to get the higher returns that stocks offer over the long run, you have to be willing to accept the risk that the returns won't meet your expectations.
Valuation risk - the chance that a stock or asset is priced too high. Usually this happens when people get overly optimistic about the future.
Stock or industry-specific risk - the chance that a particular stock or industry will be adversely affected by some factor that doesn't affect other stocks or industries. For example, if a successful chief executive unexpectedly resigns, that would probably cause only that company's stock price to fall.
Implementation risk - the chance that a company will not execute its business plan or strategy. This is especially important in a merger of two big companies. Many things have to go as planned for all those happy, much-ballyhooed, synergies to occur.
Generally, you get compensated for taking on risk (the chance of bad stuff happening). If you invest in short-term Treasury bills, you're going to get the return that you expected, but your return will be pretty low - approximately what the rate of inflation is. A diversified portfolio of stocks gives you a higher expected return, but there's also a chance that you're going to get less than you expected. Fine, you say, there's a trade-off between risk and return. Everybody knows that. But here's the part that a lot of folks don't understand: If you invest in a single stock or sector, you may get a high return, but there's a large probability that you won't. The interesting thing is that as you get less diversified, your risk of getting less than you expect rises faster than your expected return. The market compensates you for taking on risk that can't be diversified away, but if you're going to take on some dopey risks, don't expect anyone to pay you a higher return for it. In other words, you don't get much benefit from putting all your eggs in one basket. You may get lucky, but that's not the same as an expected return.
I'm not a big risk-taker. Not only do I have an ethical and regulatory obligation to keep clients from taking too much risk, but I also know that neat little trick about not getting compensated for taking on silly risks. So count on people like me for a diversified portfolio that aims to meet your investment goals without taking outsized risks; if you want to bet on the next Dell, do that yourself. It's true that people don't tend to get rich quickly by having a diversified portfolio, but a lot of people have become quite wealthy by earning steady returns and saving regularly. And a lot of people have stayed or become poor by chasing after the quick buck.
I figure if I take on a little more risk my portfolio will do better.
© Dorato Capital Management, LLC. All rights reserved.
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