5 Things You Should Know About Risk and Your Investments

By Brett Carson | U.S.News & World Report LP

Risk is an integral part of investing. Generally speaking, it is the counterbalance to return. Although we hear many money managers and advisors talk about "risk management," it is a rather ambiguous phrase. Today, risk and volatility are often used interchangeably, which is an overly simplistic definition promoted by academia. However, a recent memo published by Howard Marks, the Chairman of Oaktree Capital Management, does a fantastic job at providing a more accurate description. 

Marks may not be familiar to the average investor but he is highly respected among the world's best money managers, including Warren Buffett. In short, risk carries many different forms and cannot be completely quantified. Here are a few key points I took from his memo, titled, "Risk Revisited."

1. Volatility is not risk. Academia has defined risk as volatility because it can be measured. It is a foundational concept underlying the majority of financial models. Stocks are often assessed using their betas, or their fluctuations, in relationship to the market. In fact, beta has become perversely ubiquitous with risk.

This fallacy often lulls investors into a false sense of security and is usually coupled with a woeful lack of understanding of risk. For example, the utility sector's beta is about half that of the Standard & Poor's 500 index (depending on the time frame measured). It would be a grave mistake to assume that by purchasing a utility, one is exposed to half of the risk of the market.

2. Risk is the potential to lose money permanently. Continuing with the utility company example, there are a plethora of risks associated with stocks. Volatility may provide a modicum of insight into the overall risks. However, it dupes the investor by failing to account for anything company specific. If the market were to drop 10 percent because of a geopolitical conflict, volatility or beta might do an admirable job of forecasting the utility company to decline roughly 5 percent.

Yet, it fails to predict the impact falling natural gas prices or a change in legislation may have on any particular company. Additionally, if the entire market declines from a global macro event, capital is not permanently lost. A patient investor can usually wait for a recovery. Only when you sell the investment do you realize an actual loss. When something fundamentally alters a company's business, the risk has the potential to be permanent. 

Think about what the iPhone did to BlackBerry or what the iPad has done to personal computers, or PCs. Beta, volatility and even crystal balls failed to predict these fundamental shifts.

3. Risk is necessary. Attempts to predict the future will most often lead to failure. However, an investor can understand how the risks relate to each company without necessarily predicting the exact outcome. Great investors are astute at thinking of a range of possible outcomes and selecting investments that have more ways to win than lose.

If I own a company that sells natural gas, I have to consider the range of outcomes if gas prices will rise, fall, or remain flat over coming years. Clearly, there is risk should prices fall or even stay flat. However, if I feel the stock is appropriately accounting for this risk, and I can envision a number of paths toward higher prices in the future, my downside could be limited and potential reward attractive. As the popular adage goes, "There is no such thing as a free lunch." Smart investors take on a measured amount of risks, which cannot be captured by a stock's historical volatility. 

4. Nobody knows the unknown, but some investors don't know this. If beta is a reasonable indication of market risk, then one can reasonably estimate performance given a forecast of the overall market. However, most investors realize this is a loser's game, as nobody knows where the market will be in the near and long term. Unlike the earlier gas price example, there are an infinite number of interconnected and complex unknowns or "black swans" that could impact the market. These could be wars, terrorist attacks and disease epidemics, among other possibilities. None of these risks can be captured by historical volatility metrics like beta.

5. Prudent acceptance of risk is superior to shunning the unknown. Given the widespread reliance on beta as a measurement of risk, modern portfolio theorists have concluded that certain asset classes and subsets of asset classes offer higher returns, while others offer more safety. Eugene Fama and Kenneth French famously touted their three-factor model used to predict expected returns while they were both professors at the University of Chicago Booth School of Business. Small-cap stocks are considered risky and thought to offer long-term returns in excess of safer large-cap stocks. If this theory were accurate, though, shouldn't every investor allocate a large portion of a portfolio to small caps? 

Of course, the answer is "No." Return is not guaranteed. It is merely possible. A smaller company may face more risks than a larger company, none of which can be precisely known. If the smaller company successfully mitigates those risks while growing their business, the investor ought to be more handsomely rewarded. Regardless of the expected return, the risks remain immeasurable and the outcomes unknowable.

Some investors are highly conservative and often shun risk. However, this leaves an investor vulnerable to the risk of missed opportunities. Just as it would be imprudent to place all of one's eggs in the proverbial small-cap basket, it would be a mistake to shun risk all together. A far more logical approach is to assess the returns needed by the individual and expose the portfolio to risks the investor can tolerate.

Risk must be taken or there will be no return. If an investor has a short time horizon, they should wish to avoid illiquidity risk, but they may be comfortable with leverage risk or credit risk. On the other hand, just because an investor has a high risk tolerance does not mean it is smart to take unnecessary risk. The ideal portfolio manager should have a ceaseless desire to understand the risks facing his or her investments, while simultaneously acknowledging he or she can only be sure the future is unknown.