Risk

NorthernJoe

I find the concept of risk fascinating 

I deal with it every day in my job (NHS consultant). I am comfortable with absolute & relative risk & of course accept that perception of risk is individualised. Most of what we deal with in the clinical world of course, has a quantifiable risk. 

Despite all that, I find many aspects of investment “risk” to be perplexing. 

There is much talk of “risk tolerance” but to me it seems it’s more about beliefs. 

Everyone would “tolerate” a drop in their portfolio of 40% if they truly believed that over the long-term they would recover those paper loses and enjoy health net growth. 

Yes, I know it is about behaviours & that when experiencing a loss of 40%, those with a “low risk” tolerance will bail out and solidify their loses. Again however this surely more about beliefs – those who believe that past performance is indeed indicative of future results & that in the long-term, a well-diversified portfolio will generate significant returns will probably buy even more assets if they can in a downturn.

And so the crux of my question is, are those who truly believe in the principles above really actually taking a “risk” at all? 

[Deleted User]

"Risk tolerance" is a bogus measure designed to benefit the financial services industry rather its clients, imho.
Ask an individual whether he would tolerate any return broadly akin to his neighbour and the likely answer is Yes.
Ask an individual whether he would tolerate a 50% loss on his investment - as if he were to be singled out for that fortune - and the likely answer is No. 
The lower the expectation of the client, the easier it is to meet. And once a client's "risk tolerance" has been determined, that becomes something of a free pass for the financial services industry:- "Poor subsequent performance? You tied our hands. Your fault."

Eyeful

The market may go down and stay down, in real terms for a long time. The market may recover but drops sharply before the person needs to sell their assets. You may well buy more assets in a down turn but those assets may go on down to bankruptcy, stay down or only recover very slowly. 
They get a higher return investing than they do saving because they are taking on more risk.
They can "truly believe in those principles" as much as they like, but they are still taking a risk. 

dunstonh

Everyone would “tolerate” a drop in their portfolio of 40% if they truly believed that over the long-term they would recover those paper loses and enjoy health net growth. 

I disagree.  In my experience that is not the case.  Some people cannot tolerate a 1% drop if they see it.  if they dont see it and it happens in between statements and you tell them it happened they will shrug it off.

And so the crux of my question is, are those who truly believe in the principles above really actually taking a “risk” at all? 

How about a market fall that takes 10-20 years to recover?   How about those drawing an income that cannot afford to that have sort of volatility?

Complacency is often the biggest risk.

Thrugelmir

NorthernJoe said:

I find the concept of risk fascinating 

I deal with it every day in my job (NHS consultant). I am comfortable with absolute & relative risk & of course accept that perception of risk is individualised. Most of what we deal with in the clinical world of course, has a quantifiable risk. 

Despite all that, I find many aspects of investment “risk” to be perplexing. 

There is much talk of “risk tolerance” but to me it seems it’s more about beliefs. 

Everyone would “tolerate” a drop in their portfolio of 40% if they truly believed that over the long-term they would recover those paper loses and enjoy health net growth. 

Yes, I know it is about behaviours & that when experiencing a loss of 40%, those with a “low risk” tolerance will bail out and solidify their loses. Again however this surely more about beliefs – those who believe that past performance is indeed indicative of future results & that in the long-term, a well-diversified portfolio will generate significant returns will probably buy even more assets if they can in a downturn.

And so the crux of my question is, are those who truly believe in the principles above really actually taking a “risk” at all? 

Question for you. How many types of investment risk can you list off the top of your head?  The one thing that risk factors have in common in investing is uncertainty.  A loss of 40% is only crystallised when an investment is sold. Volatility is not risk either. Volatility is a measurement of how rapidly or severely the price of an investment can change. Risk is the probability that an investment could see a permanent loss in capital value. 

JohnWinder

I’ll buy your line of argument, and agree that being paid as a NHS senior consultant you’re likely at very little risk whatever you invest in because a 40% drop in assets value wouldn’t affect you in the slightest even if they never recovered. And there are plenty of us in the community less well paid in the same position, at least while we’re still working.

But I think your conundrum arises from us not thinking of risk in the right terms, or different terms at least. You’re talking about risk in standard deviation terms - a volatility measure. Try thinking about investment risk in terms of uncertainty that matters. For the NHS man with a couple of pensions they can live on comfortably, housing assured etc, does a 40% drop in asset values, permanently, matter? Likely not; risk does not exist from this viewpoint. For the low income battler it’a horse of a different colour: the money that was going to buy a barely adequate lifetime inflation indexed annuity next year just got trashed to the tune of 40%; or their planned house deposit now buys a house with half the bedrooms they need. That asset price value drop is consequential, and so is risky.

The other aspect to this is that you referred to risk 'tolerance'. Without wishing to put words into Humpty Dumpty’s mouth, risk tolerance might generally mean how one will feel about the risk being realised. But it can be useful to keep risk ‘capacity’ in mind when the need to think of risk tolerance arises. Because if the battler can’t buy the annuity they need because asset prices fell 40%, no matter how calm they are about a 40% drop they have no capacity to absorb that risk since they now face a lifetime on an inadequate annuity. So probably better to expose yourself to investment risk you have the capacity to take rather than tolerance to take.

Apodemus

Interesting discussion!

I wouldn't agree on the "belief" question - some people are simply not built to be able to step back and take the long-term view, living much more "in the moment" and taking any loss to heart, even if they can rationalise that the loss may only be on paper and may only be temporary.  That's not a criticism of these people, it's basic biology and an evolutionary benefit for traits to have a variation across a population  (cf neophobia in rats).

I'd also agree with Zingpower that there is a certain bogus element and an industry-wide drive for us to strive to "beat the market" rather than simply comparing returns against our own personal financial goals.    

sevenhills

Eyeful said:

The market may go down and stay down, in real terms for a long time.

That depends what you call a long time. Its a matter of what is likely. One of my beliefs is that the rich always get richer and you have got to be in it, to be part of it.

We have never had zero interest rates, that is a possibility, but the Bank of England are buying millions in the form of QE, so the Government will ensure the stock market does not fall. But they do make mistakes.

So what are the odds of the stock market being lower in 5 years, very low?

Bobziz

I would hope that an IFA would put risk into context for their clients. For a DIY investor I wonder how many see the risk rating against particular fund and assume that high risk is high risk regardless of the period of investment. If you're investing for 30 years and don't need an income then you could argue that a low risk fund is actually higher risk to your financial health than a high risk fund....

Albermarle

I wouldn't agree on the "belief" question - some people are simply not built to be able to step back and take the long-term view, living much more "in the moment" and taking any loss to heart,

I agree with this sentiment. The OP is very rational in what they say but many ( the majority) can not rationalise risk in this way and are driven more by emotion and misinformation/misunderstanding. 

underground99

Bobziz said:

I would hope that an IFA would put risk into context for their clients. For a DIY investor I wonder how many see the risk rating against particular fund and assume that high risk is high risk regardless of the period of investment. If you're investing for 30 years and don't need an income then you could argue that a low risk fund is actually higher risk to your financial health than a high risk fund....

Yes, IFAs here frequently talk about 'lower investment risk' options having 'shortfall risk', i.e. what you end up with falls short of your objectives because the amount you are expecting to put in plus the low rate of growth isn't likely to be enough unless you're lucky.  That can probably be seen differently from the fact that a moderate or higher growth produce might fall short of what you need on a specific date just because the market happens to be down rather than up.

Likewise a cash account or bond has 'inflation risk' because inflation will erode the fixed returns whereas corporate revenues / profits / equities performance would be expected to be higher if goods and services had higher sale prices.  Some might say that is just another way of saying that you might fall short of what you need if you use the slow-growing or non-growing income-paying assets; but inflation is a risk to be aware of that affects some asset classes more than others. When Thrugelmir asks rhetorically how many types of risk you can name, it doesn't really matter what you call them, but what you understand about the different sorts of things might happen to knock you off course, so that you can make sure you defend against them.  Or even if you can't defend against them, at least you won't have the same extreme level of disappointment when you see them happen, if you were well prepared that they could happen.

Over a really long term objective where you can reasonably expect to get a mix of lots of up, down, and nowhere periods across global markets, the higher growth options are more likely to give you a decent result.  But if you don't need to get that higher growth rate, there is no point taking the risk of going for it just for the sake of it. Given the various unknowns - if you don't need a massive return to be comfortable, something more 'reliable' with a more modest return can be more suitable than something that carries risk of large loss from time to time.  So some will go more moderate risk even though they know that an international equity fund is 'best' for long term growth.