Without risk, there can be no return. This is the unfortunate relationship between risk and return. Investors who seek out a higher return will usually be met with higher risk. Those investors who want a lower risk investment may also have to settle for lower returns.
Do investors have any control over risk when increasing returns? The relation between risk and return isn’t linear. This gives the impression that investors do have some control over risk. That gets at the heart of this article, which looks at why risk is an important consideration when investing.
What is Risk?
Risk has many interpretations. Under the same conditions, two different investors may view risk differently. How can that be? Our view of risk comes from our risk tolerance profile. Some people are prone to taking risks, while others are risk-averse. Then there is a wide spectrum of people who fall between these two opposite poles.
But that doesn’t really answer the question — what is risk? In general, risk is the potential loss of capital that an investor assumes. When an investor buys shares of stock, they assume a certain level of risk. This, of course, is not a life-threatening risk but instead a financial risk. The next question to ask is — how much risk has the investor taken?
Whether the investor has analyzed their potential risk or not, the risk is there. But as mentioned above, risk is viewed differently by different people. An investor with a $10 million net worth who buys $50,000 worth of shares in a highly volatile pharmaceutical company isn’t assuming much risk. $50,000 is only ½ of a percent of the investor’s net worth.
However, someone making $50,000 per year with a net worth of $150,000 investing the same amount in the same stock is taking extreme risk. Their investment can wipe out one year’s worth of earnings or ⅓ of their net worth.
This doesn't necessarily mean the pharmaceutical company is a bad investment. The high net worth investor might experience a 50% drawdown in year two because the stock declined. Then in year four, the stock spikes up, and the investor makes a 125% return off their original investment. This is only possible because the investor was able to ride out or wait out the stock's volatility. He did not need the invested cash for living expenses or the short-term.
The lower net worth investor may not be able to tie up $50,000 for four years, especially if the investor may need it for the short term.
In summary, risk is the potential loss of capital in the pursuit of return.
Why consider risk when investing?
Blindly chasing returns can expose investors to unintended risks. Taking account of the risks that a potential investment presents helps to reign in ambition. As an investor analyzes an opportunity and begins to identify the various risks involved, they may try to manage those risks. Risk management can lead to lower returns, but the end result can be more balance between risk and return.
Looking at it another way, if risk is the potential loss of capital, trying to find ways to decrease that potential is why risk should be considered when investing.
Can risk be controlled?
How does an investor decrease the potential for loss of capital? That is where risk mitigation comes in. Risk management means seeking ways to control risk, at least to the extent that it can be controlled.
Identifying general market risk and asset-level risk are two great starting points in managing risks. If risk can be identified, it can be mitigated. In its simplest form, this might mean avoiding the investment altogether.
Other areas to take into consideration when trying to minimize risk include:
- What percentage of the investor's net worth is going into investment?
- Are there partners involved in the investment? What are the strategies for resolving conflicts or continuation if a partner becomes incapacitated?
- Having a will is a good move but does not exonerate the investor from the probate process. For some investors, going the extra step and creating a trust might be a better option.
- Have various tax risks (specific to the investor) been identified?
- How does the opportunity fit into the investor’s overall estate plan?
- What creditor protections have been put in place in an attempt to shield the investment?
- Are there any capex maintenance issues coming up within the next few years (i.e., roof replacement, parking lot update, etc.)?
Working with a real estate attorney and real estate tax accountant can go a long way to ensuring the investment is a proper fit and that many identifiable risks have been considered. Additionally, in our opinion, working with a realtor who is not focused on the transaction but instead takes on more of an advisory role can provide an additional level of analysis about the opportunity and its risks.