Welcome to another new series here on Macro Mondays! This time, we will be discussing risk and diversification and why both are important considerations in portfolio development. Over the next five weeks, we will be covering the importance of maintaining a diversified portfolio, while at the same time ensuring your risk levels are in line with your comfort levels.
In broad terms, risk involves exposure to some type of danger and the possibility of loss or injury – whether that’s to your physical health, social status or something else. People face numerous risks every day, doing things like driving to work and texting while walking – or worse, while driving (please don’t). There are also risks that stem from things you aren’t doing (but should) – like getting enough sleep, exercising regularly and eating a healthy diet.
Of course, some activities are riskier than others. Certain adventure sports, for example – such as free climbing, BASE jumping, big wave surfing and bull riding (the “most dangerous eight seconds in sport”) – expose participants to higher-than-normal levels of risk. For many adventure enthusiasts, that’s the whole point. Still – no matter what risks you face – there are usually ways to lower the possibility of loss or injury, whether that’s learning to hold your breath as a big wave surfer or wearing a seatbelt as a morning commuter.
Reality vs. Expectations
In the investing world, risk refers to the chance that an investment’s actual return will differ from the expected return – the possibility that an investment won’t do as well as you’d like, or that you’ll end up losing money. The good news: Like other dangers we face, it’s possible to manage investing risks – by learning what they are and by diversifying your portfolio. That way, one bad investment can’t do serious damage to your overall financial health.
To help you get started, this tutorial introduces risk and provides a good foundation for understanding the relationship between return and risk, as well as the importance of diversification.
What is 'Risk'?
In general, risk involves exposure to some type of danger that has the potential to cause loss or injury. In the investing world, it’s the chance an investment's actual return will be different than expected. This uncertainty includes the possibility of losing some – or all – of the original investment.
Everyone is exposed to some type of risk every day – whether it’s from driving, walking down the street, investing or something else. Even if you sit on a couch all day in an attempt to avoid risks like getting hit by a car or catching a virus, you would still be exposed to the many risks associated with being sedentary – including anxiety, depression, cancer and cardiovascular diseases. Bottom line: No matter where you go and what you do, you’re exposed to various risks every day.
Your general risk level and your investment risk level
Your personality, lifestyle and age – among other factors – play a big role in how much risk you are comfortable with. Of the millions of surfers in the world, for example, only a tiny percentage ride the really big waves at breaks like Mavericks and Nazaré – it takes a special breed of risk-taker to surf a 60-foot wave, after all. While millions of surfers are comfortable riding “regular” waves, most draw the line when the waves get really big because the risks are too high.
Like surfers, each investor has a unique risk profile that determine their willingness and ability to withstand risk. In general, as investment risks rise, investors expect higher returns to compensate for taking those risks. As an investor, the key is to find a balance that lets you enjoy reasonable earnings while still being able to sleep at night.