Words by Georgie Loxton, CFA, Founder, Liberty Wealth Partners
One of the biggest misconceptions I find myself helping people rethink is the concept of risk. Perhaps one of the most common phrases I hear uttered in my first conversations with someone is “I am risk-averse.”
I have come to understand that no one is defining risk correctly because no one ever agreed on the definition.
In traditional finance theory, risk is the ‘standard deviation’ of an investment, or how much it moves around its average return. That is also a definition of volatility. The long-term average return of mainstream US stocks has been in the region of 10% for the last 200 years. Rarely in a year do we get 10%. We either get a lot more than that, not much at all, or a negative return. The returns wiggle a lot over time. It’s precisely that wiggle that gives us the return.
Indeed, what some people are saying when they tell me they are risk-averse is that they are afraid of volatility. The volatility of stocks is broadcast on a minute-by-minute basis for the whole world to see. That’s why volatility-shy people tend to like property – although the price of a property is also volatile, it’s not visible to you daily (no one puts it on the front of your house each day), so it feels less scary.
But is the volatility of the stock market risk? I would argue no. It’s not, so long as you don’t react to it, because although the market goes down, it never stays down. Howard Marks, one of the world’s most successful investors, once said, “There are many kinds of risks. But volatility may be the least relevant of them all.”
So if volatility is just volatility, what is the risk for an investor?
There are two types of risk that matter. The first is the risk of not achieving your most cherished goals or not living the type of life you want to live; having to delay your retirement, taking a major step back in your lifestyle when you get there, or not being able to fund your child’s dream education.
The thing is, the less volatility you take on along the way, the lower your return will be. A lower return means less capital and a higher risk that you will not achieve your goals or that they will need recalibrating.
The second type of risk that matters is best described by my friend Carl Richards. He said, “risk is what’s leftover after you think you’ve thought of everything.” Donald Rumsfeld used the term ‘unknown unknowns’. They are the things that we don’t know, we don’t know. The things we aren’t even thinking about.
Morgan Housel explains, “look at virtually any decade, and you’ll see that the most important news story was something no one was talking about until the moment it occurred.” Events like Pearl Harbour, the Twin Towers, the Pandemic. Or, as Carl says, it’s not the car you see that kills you.
How do we protect ourselves from these risks if we don’t even know what they are yet?
We protect ourselves by limiting our use of leverage, which works on the upside, but is capable of producing total ruin on the downside. And we maintain liquidity. If you have all your assets tied up, you have no margin of safety for when things don’t go to plan.
In the words of Morgan, “the only way to deal with the unknown unknowns is by increasing the gap between what you think will happen and what can happen, while still leaving you capable of fighting another day.” And fighting to live another day is what
real-life financial success is all about.
Visit: Fort 51, Fort Street, George Town, Grand Cayman