“An investment is simply a gamble in which you’ve managed to tilt the odds in your favor.”
What’s more fun than a trip to Las Vegas? If you instantly said “Nothing!”, grabbed your sunglasses, and started looking for flights, you may be the type of person who feels comfortable taking a chance (also, we need to hang out. Immediately). Risk and uncertainty do not bother you.
Keep your friends close, and your ATM card closer
Heaven… or Hell…
Not the real Eiffel Tower
But maybe the thought of Vegas makes you a little queasy. All the lights, noises, and casinos trying to take your money have no appeal for you. These conflicting feelings may have to do with how individuals embrace risk. When it comes to investing, people have different feelings about risk. There is no one strategy that works for everyone. We’re all different. Our asset allocations should be, too.
But what is risk? How do we wrap our hands around it?
TYPES OF RISK
Just as casinos have different games to take your money, there are different risks that an investor needs to be aware of. Here are examples of a few.
Nothing too tricky here. Market risk refers to the ups and downs of the stock market. Although the stock market has generally trended upwards for almost one hundred years, there have been many dips along the way. Volatility is always present in the stock market.
Foreign exchange rate risk
Congratulations! You made a shrewd investment in an emerging market country, and earned a 20% return in six months! But… their currency fell 25% against the dollar, making this great investment a net loser. Foreign exchange fluctuations can wreak havoc on a portfolio. One way to offset some of this risk is to hedge your investment. This entails buying or selling a currency in order to offset some of the fluctuations.
Interest Rate Risk
Changes in interest rates can be difficult to predict. So can the effects on different asset classes. Typically, rising interest rates lead to lower prices for fixed income investments. Stocks have performed well in a rising interest rate environment, but it is not as clear whether this is caused by rising rates, or merely correlated. Since interest rates rise in times of plenty, stocks may be rising regardless of the current interest rates.
Sometimes known as default risk, credit risk is typically associated with fixed income securities. This is the risk that the counterparty will not be able to meet their obligations, potentially leaving you holding a security that is worthless.
Think of it as cashing in your chips at the end of the night. If you’re playing blackjack at the Wynn, your chips are going to be valid when you go to cash out. But if you’ve been spinning the roulette wheel at some shady casino at the end of Fremont Street in old Vegas, maybe they have enough cash to cover, maybe they don’t. You could run the risk of the casino not being able to cover their obligations. As in bonds, quality matters.
Unlike the blackjack table, investors are able to reduce risk in their portfolio.
Besides having a bunch of pretty colors, this chart tells us something pretty significant: The returns of asset classes can be all over the place in any given year. Putting all your money in one investment, and you can be in for a bumpy ride. With asset class returns being extremely difficult to predict year to year, being diversified helps to reduce overall volatility. After all, you wouldn’t put all of your money on one hand, would you? Oh, you would? Well, don’t (but seriously, we need to hang out).
Please don’t do this
Never a good idea
Another way that diversification helps to reduce risk has to do with how correlated assets are. This useful-but-not-as-colorful chart displays the correlations between different asset classes.
What does this mean for us? That investing in different asset classes, especially those that are negatively correlated (will rise when other investments fall) will help to protect your portfolio against risk and volatility.
When it comes to investing, there are many risks we need to account for. That’s why you need a comprehensive plan, in order to manage and mitigate risk as best you can.
Take risks in Vegas, not in your portfolio. And the next time you go, try not to bet it all on one hand.