Defining Investment Risk and Its Impact on Portfolio Decisions

Defining risk

[Saturday, January 10, 2009
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The definition of risk is an important concept since it plays an important role in deciding on the way which we do our investment. As taken from investopedia, risk is defined as the chance that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment. In the business academia, risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment or in other words, risk is also the volatility of the investment.

The above definitions explains why stocks are riskier than bonds and bonds are even more riskier than fixed deposits. For example, stock A has a volatility that has a price range from $4 to $8. It has a higher risk as there is always a chance that one could have bought the stock at at the peak of the range i.e. $8 and if the stock does not rebound, one could suffer losses. Furthermore, there is always the possibility that the company could collapse, leaving the stock of the company worthless. As such, bonds are less riskier as the price of bonds are much less volatile and in the event of the collapse of the company, the funds that are liquidated from the sale of the company will be paid to the bondholders before stockholders. Comparatively, fixed deposits offers capital protection but the returns is likely to be poor. Thus, fixed deposits are said to be the safest form of investment among the three.

What is not being said is that you will also be taking on a huge risk if you put your money in safe investments such as fixed deposits. This is because the returns offered by such form of investment is likely to be very poor and the return is unlikely to beat inflation in the long run. Effectively, you will be losing money since the buying power of your cash will be eroded over time. I have attached a chart of the historical inflation rate of Singapore below.

My definition of risk is rather different from the conventional definition. To me, risk is when one buys something without knowing and understanding throughly on what he is buying. If you think about it, it is a rather simple statement but one which has a lot of implications. I am rather surprised that when people buy electrical appliances such as a TV or a washing machine, they will often read about the specifications and do some thinking about whether that appliance is a worthy buy. However when it comes to investing their money, many of us often turn to friends or acquaintances to decide on what to invest in and often, even though they have may good intentions, they may not be the best people to consult on matters regarding investment.

I can’t stress enough about knowing and fully understanding the investment that you are putting your money in. For example, stocks are considered to be risky in the conventional sense because it is volatile. However, what happens if you can buy it at the lower range of the volatility such as the current bear market now ? If you can buy it near the lower range, you are actually carrying less risk because the downside is rather limited already. What happens if you found a fundamentally strong and monopolistic company available whose stock is available at a very low price ? Will you still think that it is risky to buy this company given that this company is able to generate profits year after year due to the nature of its business ? I can just go on and on with the list of examples.

Thus it is of utmost importance to understand what you are investing in. If you are investing in stocks of companies, you should look through the annual report and financials of the company before deciding. If you are investing in an investment product, you should read through the prospectus thoroughly. Only then, you will be able to reduce the risk that you are carrying when you are investing.