Defining Investment Risk

On 05/07/2010, in Investment Concepts, by Jordan Wilson

What is investment risk?

Investment risk is a form of speculative risk. Speculative risks differ from pure risks in that with a speculative risk there is a possibility of gain, not just loss or no change in status.

But what does that mean?

Is Investing a Gamble?

Gambling, like investing, is a speculative risk.

Perhaps you play poker with friends monthly. Sometimes you lose, occasionally you win, and a few times you may break even. But when the evening begins you do not know what the outcome will be.

Some authors claim the opposite is also true. That speculative risks are merely gambles. By extension, investing then must also be a gamble.

I do not agree with that viewpoint. Here are a couple of reasons why.

First, when visiting Las Vegas, there are steps that can be taken to improve your probability of success. You can study effective gambling strategies; avoid alcohol, emotional swings and sleep deprivation; only play those games with the best odds.

However, there is a reason that Las Vegas is profitable. The odds are always in the house’s favour. In the short run one may profit. But over the long haul the probability of loss is certain for gamblers.

You can also improve your probability of success in investing. Education and experience will help you become a better investor. Taking a disciplined approach that eschews emotion from decision-making (or as Alan Greenspan would say, avoiding “irrational exuberance”) will also improve your chance of success. You may decide to only invest in assets with the “best odds” as well.

Despite media stories, the markets are not a casino. Investments are not games of chance that were expressly created to provide the casino with a built in advantage. Learning to properly invest is not simple, but it is possible to “beat the house” over the long run.

Secondly, when you enter the casino with $1000 you have no idea what you will leave with at night’s end. Depending on your luck and skill, you could win $1 million, break-even, or (more likely) go home with nothing except a few free drinks and a shrimp cocktail for your efforts. And that is not factoring in a possible trip or two to the conveniently located Automated Teller Machines.

Again, investing is different. I can list numerous investments where the outcome is known with (almost) 100% certainty. If you invest $1000 in a 1 year 5% Guaranteed Investment Certificate offered by your bank, at the end of the term you will receive $1050. Or you could invest $975.90 in a 6 month US Treasury Bill (T-Bill) yielding 5% and be confident of receiving $1000 upon maturity. Unless your bank or the US government defaults on their debts, your investment is completely safe.

While it is fair to say that investment risk is not gambling, what is it then?

Investment Risk Differs Between Individuals

Investment risk is difficult to pin down. It is a concept that differs from individual to individual. What I think is risky may not be to someone else. And vice-versa. One’s personality, experiences, and personal circumstances all contribute to how a person perceives risk.

On one end of the traditional risk spectrum is the stereotypical widow or orphan. Not the ones with the enormous trust funds, but those from the world of Charles Dickens.

This group has very little money to begin with so preservation of capital is paramount. They invest in the hope of generating enough positive cash flow to buy their daily gruel. If you ask them about risk, they will say anything that could possibly reduce their original capital is risky.

The widow would definitely not want to double down at the blackjack table. She would also be uncomfortable investing in common stocks, corporate bonds, or real estate; investments with any uncertainty in repayment of the original capital.

This investor is only interested in guaranteed investments where their money is secure.

On the other end of the risk spectrum is the hot shot young Chartered Financial Analyst (CFA) working on Wall Street.

If you ask about risk, you will get a long convoluted response that probably makes little, if any, sense. One involving the Greek alphabet (Alpha, Beta), strange acronyms (CAPM, SML), fun mathematical expressions (normal distributions, variability of returns, standard deviations), and crazy men (Sharpe, Treynor).

Like the lyrics from a pop song, the phrase “variability of returns” would echo in your head.

At the end of the explanation, you would probably back slowly from the room, grab a stiff drink, and return to the widows and orphans. At least they made some sense.

Sadly for you, if you stick with this over the summer, you may just understand some of the gibberish spouted by the CFA. I apologize in advance for starting you on the path to insanity.

While the concept of investment risk is unique to each person, may I suggest that the average investor should take a view somewhere in between widows and CFAs. Probably closer to the CFA view of the world would be my recommendation, but each person must be comfortable with their own risk profile. If not, there will be many sleepless nights filled with angst and Pepto-Bismol for your growing ulcer.

Investment Risk Defined

In looking at risk from the middle of the spectrum, investment risk is simply the probability that the actual return on an investment will be different than the expected return.

The greater the probability that the returns will differ, the greater the risk. The greater the certainty that the expected result will actually transpire, the lesser the risk. This is where the phrase “variability of returns” arises and we will look at it in detail later.

If you invest $975.90 in a 6 month, 5% US T-Bill you will receive $1000.00 at maturity. The US government issues and guarantees payment on T-Bills. So unless you believe that the US government will default on their debts you are certain to receive the full amount.

In terms of the above definition, the probability that the actual return on the investment ($1000.00) will be different than the expected return ($1000.00) is zero. The actual and expected returns are identical. You know the actual outcome with 100% certainty.

For this reason the interest rate offered on short term US T-Bills is commonly considered the risk-free rate of return. There is no risk that the expected and actual returns will be different. The investment itself is considered to be risk-free.

Note that as we shall see in an upcoming post, even T-Bills may not be free of risk.

What about a common share of ABC Company? The current share price is $9.76. Professional analysts agree, on average, that the share price should increase to $11 at the end of 6 months. By investing $975.90 into ABC and not US T-Bills, you expect to receive $1100.00 after 6 months. An improvement from the $1000.00 that you would receive from the T-Bill investment.

You invest your money into ABC shares, then promptly fly to Peru to spend the 6 months studying Incan civilization in the Andes. And thinking about that extra profit you are earning.

At the end of the 6 months you return home and go to sell the shares, fully expecting to enjoy that extra $100 in profit. Imagine your surprise when you find that the share price is now trading at $9.00 and you have actually lost money on the transaction. In this case the expected return ($1100.00) was significantly different than the actual return ($900.00). That is the impact of investment risk.

We will look at the relationship between risk and returns in great detail as it is critical to understanding the investment process.

For today though, I ask you to think about the following scenario.

How Do You View Investment Risk?

You have $1000.00 to invest and two options are available. Unless stated otherwise, we will always ignore costs in simple examples (e.g. transaction costs, taxes, management fees).

You can invest in a 1 year US Government Bond yielding 5%. At the end of the term you would receive $1050.00 with 100% certainty.

Or you can invest your money in ABC, trading at $10 per share. Expert consensus is that the share price will rise to $10.50 in 1 year. This will provide the same expected 5% return as with the US Government Bond.

But ABC is not the US government. Also, other factors may be at play that impact the certainty of the price forecasts. The probability of actually receiving the expected return is less than 100%. You may receive more, you may receive less. It is impossible to predict with certainty.

Which would you choose for your investment?

What if the consensus on ABC increased to $12 per share? Or $14? Or fell to $8?

What if there was no average consensus? Rather, there is a 25% probability the stock falls to $8, a 25% probability that it rises to $16, and a 50% probability that it rises to $12?

Do any of these new scenarios change your investment decision?

If so, do you know why you changed your mind?

We will consider these examples when we get to the risk-return discussion in a few weeks.

Next up though, the two components of investment risk and factors that influence them.

Enjoy your weekend. I am off to Las Vegas to make my fortune.

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