Risk, what is it, really? Risk is a reality that exists in all aspects of life, it’s that simple. When it comes to your finances, risk is defined as the potential loss of capital. It’s also referred to as volatility and divergence from a specific index or fund benchmark. Let’s drill down into this concept further.
Volatility
Volatility is a measure of how an investment varies from its average over time. The problem with equating risk as volatility is that the relationship between an investment’s price and its intrinsic value is underestimated. For the most part, it’s an indication of the fluctuation in perceived value, which is based on past return patterns and doesn’t take into account other threats that may influence returns such as a company’s financial structure.
A better way to predict the returns you’ll receive on an investment is to estimate its intrinsic value and then compare it to the asking price.
Divergence
An alternative view of understanding risk is that it’s a measure of divergence from a set standard. Basically, this is measured by tracking the difference between a fund’s returns and a specific benchmark.
Following this method of error tracking, share returns that have high tracking indices are seen as high risk. The value of this measurement depends on your financial objective. If you’re an investor who wants to track the index, then using divergence as a measure of risk is valid. However, if you’re looking to generate wealth over the long term, error tracking may not be recommended.
Risk is loss of capital
To fully understand risk, you need to realise that it is not only about the potential of permanently losing your money, but also the scale of the loss.
In order to determine this, the ‘maximum dropdown’ needs to be measured, which is the biggest ‘peak-to-trough’ decline of a fund’s returns over a long-term time period. In addition, months of recovery need to be considered – the amount of time it takes for the investment to recoup from the decline.
It should also be noted that a share’s price drop doesn’t necessarily increase its risk if the drop is temporary.
If you’re going to use this as the definition of risk, it’s worthwhile considering investing in companies whose shares are far below their intrinsic value. Generally, the best strategy would be finding exceptional value that may lead to lower risk.
Be mindful of risk, not afraid
It is good to be mindful of the risks associated with investments but try not to let it frighten you into being too conservative. Rather, be aware of risk; see it as a way of identifying potential problems.
Employing a conservative strategy can serve you well because its aim is to preserve your money. However, you can’t expect high returns. By adding a bit of risk, you can reap the rewards of potential high returns.
With the help of a financial advisor and investment manager, you can find the right asset class allocation via unit trusts to fit your investment plan and your risk profile.
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