Let’s Talk About Risk
Is the stock market really that risky?
Many would-be investors are afraid to start because they think stocks are risky. They may think investing in stocks is no better than gambling, or they might have heard about people losing money during a stock market crash.
But is the stock market really risky? The short answer is technically, yes. But the long answer requires a wider conversation about risk.
What is Risk?
Risk describes the probability that an investment’s actual return will deviate from the expected return. Of particular concern to investors is the risk that an asset will lose money, either in terms of real dollar amount or of spending power. How much risk you should take depends on your age, goals, time horizon and risk tolerance.
There is no such thing as a risk-free asset. Stocks have risks. Bonds have risks. The “safe” cash in your bank account has risk. Understanding the unique risks of each asset class is essential to constructing a portfolio to reach your goals.
Types of Risk
There are many types of risk, but there are broadly three types of risk that are relevant to investors.
Generally, when we're talking about the broad risks of investing in the stock market, we’re talking about market risk. This is also known as volatility, or the sometimes large and unpredictable short-term fluctuations in the overall stock market. Over long periods of time, market risk has less of a negative effect on your portfolio.
There is also idiosyncratic risk, or the risk of owning an individual stock. Say a company becomes embroiled in a scandal and their CEO resigns. Or the company fails to meet expectations for earnings. The stock would likely drop as investor confidence wanes. Unique, company-specific risks can be hard to predict, and if you have a significant chunk of your investments in a single company, you’re taking on more risk than if you were simply invested in the entire stock market. Sometimes taking on this risk can work in your favor, but you need to be aware of the downside.
Then there's inflation risk, or the risk that an asset won’t keep up with inflation. The broad stock market has historically outpaced inflation by about 7% on average annually. The average return of treasury bonds is considerably less, and the rate of return on cash makes them a particularly risky asset to hold if your goal is long-term appreciation or capital preservation.
Why Take Risks?
So why take risks in investing at all? Well, depending on your goals, you have to accept some degree of risk.
If your goal is retirement and you’re in your 20s or 30s, taking on market risk by investing in stocks, while volatile in the short term, is the best way to reach your goal. That’s because you need the higher return that stocks deliver and you have a longer time horizon and more time to recover from a stock market crash. When you take the long-term view, investing in stocks doesn’t seem that risky.
On the other hand, over the long-term, not investing is the most risky thing you can do with your money, as inflation is guaranteed to erode your spending power over time. The only way to avoid this is to invest in assets that beat inflation, like stocks and real estate.
Assets that experience volatility in the short-term tend to compensate investors over time for their risks. The more risk you take, the higher the potential return, although there are no guarantees.
Similarly, we take on inflation risk by putting money in cash for short-term goals because the risk we want to avoid is volatility. It’s unlikely inflation will do much in such a short time anyway (even with recent inflation). But you don’t want to save for a vacation by putting money in stocks only to have the stock market crash a month before you book your flight and hotel.
How to Mitigate Risk
Some approaches to investing carry more risk than others. For example, investing in single stocks tends to be highly risky because of idiosyncratic risk. But investing in the whole market through index funds provides diversification and less volatility.
Too much concentration in one stock, sector or factor can expose your portfolio to more than the market risk. By just owning the whole market you can mitigate this risk.
As a rule of thumb, you should invest in stocks for a goal that’s greater than 10 years away and avoid them for a goal that’s less than 10 years away.
How Much Risk Can You Accept?
Everything you do with your money involves some kind of tradeoff. Do you put your money in stocks and risk short-term losses? Or do you stick your money in a low-rate savings account where inflation will erode its purchasing power over time?
In determining how much risk and what kind to take on, consider two similar but distinct concepts: risk tolerance and risk capacity.
Risk tolerance is the amount of risk you’re comfortable taking. Risk capacity is how much risk you need to take to reach a goal. The two may be in conflict, but an investor must know how to reconcile them. If you cannot accept the additional risk needed to reach your goal, you may need to adjust your goal. Or if you have a high risk tolerance but a low risk capacity, meaning you don’t need to take on extra risk to reach your goal, you may want to lower the risks you’re actually taking.
The level of risk you accept depends on your goals and your time horizon. The farther away your goal, the more short-term volatility you can accept to achieve higher returns. The closer your goal, the riskier it becomes to put your money into volatile assets like stocks.
We can say investing in the stock market is risky. But over the long term, if risk is what’s holding you back, consider that the real risk is in not investing.