There were a few people who were confused with part 4 i.e. The introduction to risk in general. Let me clarify what the take-home message was for that article.
We know that there are two parts that we have to figure out when it comes to any type of risk that we are looking at in life in general:
1) What is the possibility or probability of a loss or injury occurring?
2) How big can those losses or injuries be when they occur?
So, to reiterate no matter what activity in life we are looking at that has risk we want to identify these two components to get a better understanding of how much risk is involved.
In this post we are now going to turn our attention to risk in investing.
So, let's modify our general definition of a risk which was the possibility or probability of loss or injury to a more focused definition of risk as it pertains to investing.
For the most part the specific loss or injury for investors is losing money and going back to our takeaway message from the last post we want to identify.
1 1) How frequently we might see losses in our investments?
2 2) How big those losses might be?
Let's compare a lower risk investment with a higher risk investment. To see what this looks like with our lower risk investment here are the annual returns over a 10-year period that we might see.
We see that in year 1 there was a return of plus 2% year 2 was plus 4% year 3 was plus 2% and so on.
From our framework for assessing risk we want to see how often there are losses and how big these losses are when they occur.
We see that there is only one year in which there is a loss year 6.
The return this year was negative 1%.
So, in total there was 1 year when we saw an losses and the size of that loss was pretty small
Now let's take a look at the annual returns over a 10 -year period that we might see with our higher risk investment.
Now we see that we lost money in four years and the sizes of those
losses tended to be much bigger
So, we see losses more often and the sizes of those losses were bigger.
This is indeed a riskier investment.
Now let's see what happens if we put one dollar into each of these two investments.
Looking at our lower risk investment we see that our $1 grows fairly slowly but also fairly steadily.
At the end of 10 years our $1 has grown to $1.25 cents. This is a cumulative gain of 25%.
Looking at our higher risk investment we see that our one dollar fluctuates much more while it was a bumpier ride our one dollar has grown to $1.25 cent. This is a cumulative gain of 50%, which is double the return of the lower risk investment.
So, our higher risk investment option had a higher return over the time period we were looking at. But what would our results be if we looked at a different time period within this range.
For example, let's say we invested our one dollar at the beginning of year 3 and we invested for 7 years.
With our lower risk investment option our $1 will grow to $1.16 cents for a cumulative gain of 16%.
But with our higher risk investment option our $1 essentially ends up where it started
actually ending up just slightly under $1 in value for a very small loss.
So, this is a good introduction to risk and investing. It shows that if you want the potential of higher returns it comes at the expense of more risk.
But just because you take on more risk does not guarantee you'll get a higher return as we've just shown.
The fluctuations in an investment portfolio are the main way average investors should look at risk. The amount of fluctuation is often also called volatility and you'll often see these three terms used interchangeably fluctuations, volatility and risk.
They all essentially mean the same thing. Now don't worry if you don't know what a portfolio is. Yet we haven't got there but we will shortly we have one more post to go on this section on risk which we will use to explain the difference between a stock and a bond.
Thanks for reading this article.
If you want to read the previous articles of this series, click here
No comments:
Post a Comment