In area of finance risk and return are related. In general, increased risks should be compensated with higher returns. However, it is crucial to know that increased risk does not guarantee a higher return (Chen 2020).
An easy way to illustrate this relationship is when the bank issues you loan. When you borrow money from a bank, it will require its money back with interest in order to be compensated for taking on the risk of you failing to meet the repayment terms. What is important to understand in this example is that the interest rate (which defines the returns the bank expects to make) is determined by how much of a risk your loan arrangement is to the bank. To provide compensation for the risk a higher interest rate will be applied to a riskier loan. This is all good and well, if you’re a bank, but how does this apply to achieving financial independence?
Application to personal finance
In order to achieve financial independence everyone will need to take on risk in order to build a source of passive income. This is also where I believe that many people come unstuck because they lack a basic understanding of how risk fits into the overall picture of their personal finances. In my opinion having an understanding of the following 3 key areas of risk, as they pertain to your situation, will help you make more sound investment decisions:
Personal risk tolerance
Everyone has a slightly different appetite for investment risk. This level will change with time as well as depending on personal circumstances. Generally speaking, people at the beginning of their working careers, have a higher capacity for investment risk because they have more time to re-accumulate lost capital in the event of portfolio under-performance when compared with someone that is towards the end of their working career. This additional time also affords them the luxury of being able to tolerate short term volatility in the pursuit of long-term gains.
Risk tolerance is sometimes referred to as your ‘ability to sleep at night’. Some people are comfortable with large portfolio volatility whereas others are not. In the FFE house our understanding of our own risk tolerance is derived from understanding our own cash flow situation; having discussions around the consequences of negative portfolio returns; and understanding their impact on our road to financial independence.
If you go through the exercise with a financial advisor, they will ask you questions in order to determine your risk tolerance. If you choose to do this yourself you can assess your own financial situation under different scenarios to see what you can tolerate. Or better yet, jump in the deep end and start investing small amounts of money and monitor your feelings and actions as your portfolio rises and falls.
Estimating upside and downside risk
All investments come with both upside and downside risk which are dependent on the probability that the investment opportunity provides positive or negative investment return as well as the extend of those returns. For an investor to make a sound investment decision the probability of upside movements does not need to be higher than the probability downside movements. However it is important that the expected value be positive and that the investor be comfortable with the downside risk; this comfort level comes from assessing their personal risk tolerance.
In Australia we have a saying called ‘safe as houses’ which implies that property values only go up. This is a classic example of failing to give enough consideration to downside risk. Even through, in the real world the probability of up and downside movements are impossible to determine with 100% accuracy it is still important to consider which movement is more probable. This will aid in decision making for your course of action when presented with investment decisions.
Let’s take the example of a game where you roll two 6-sided dice. The cost to play is $1, if you roll a double 6, you will be paid $30. Is this a game worth playing?
To calculate this, you need to calculate the expected value and determine if this is greater than the cost to play. The equations are as follows:
Since $0.833 is less than $1 the expected value of the payoff is less than the cost of playing the game. This means that after many rounds of the game the player will get back $0.833 for every dollar that he/she pays to play. The negative expected return (0.833 – 1 = -0.167) indicates that the game in its current state is not worth playing. As an investor if we were able to re-negotiate terms such that the cost to play is $0.50 then the game could be worth playing. At a cost to play of $0.50 this is an example of how the probability of positive returns (1/36) is less than the probability of negative returns (35/36), however because the expected value is positive (0.833 – 0.5 = 0.333), and assuming that the investor is comfortable with the downside risk, this would be a good investment decision. On a side note downside risk in this case is actually much higher than $0.50, but I’ll discuss it more detail what that number is and how to estimate it in another article.
In this example the probabilities are all known upfront which makes the expected value easy to calculate. It’s also the same reason why overall punters will lose money at the casino. As mentioned earlier, in the real investment world probabilities and pay offs are not set, but rather must be estimated, this is where the finance industry and markets come to into play. One of the functions of the finance industry is to use information to value risk in order to find a discrepancy and then profit from it. This will lead on to the topics of arbitrage and efficient markets.
Identifying types of risk that affect an investment
There are many different types of risk, some are relevant to asset classes in general, whereas others are specific to certain types of investments. When considering an investment opportunity, it is important to be able to identify as many risks as possible. This will help you to estimate your required rate of return for your investment and what you should pay. For an investment decision to be a good choice, your expected return must greater than or equal to your required rate of return. Here’s a non-exhaustive list of risks that can help prompt you when identifying risks for your investments.
- Volatility
- Legislation
- Taxation
- Interest rates
- Inflation
- Liquidity
- Foreign exchange rates
- Credit risk
Investing is inextricably linked to risk
Fundamentally, investing is the act of taking on risk in order to produce some type of return to enable an investor to have increased purchasing power in the future. What that risk involves is giving up the opportunity to consume capital now by putting it towards a venture that has a chance of producing more output in the future.
Let’s take for example a village of farmers that are producing enough potatoes to feed themselves. One day one of the farmers decides that he wants to produce more potatoes so he decides to spend this season developing a new kind of plough that will allow him sew more crops. So instead of sewing the normal number of crops, he chooses to sew less crops and use his excess time and effort to develop this improved plough. Now the farmer will expose himself to the risk of potentially starving because instead of growing enough potatoes for today he is spending his time and effort developing a new plough, however if he is successful his farm will have an increased production capacity.
We can see in this example how investing is linked inextricably to risk – the farmer must risk not having enough to eat in exchange for the chance of higher production in the future. We can even go as far as to say that investing is an act of exposing an investor to various elements of risk. In the modern world there are a huge number of investment opportunities that carry all sorts of different risks. What is important for you, as an investor is to have an understanding of 3 things.
- How much risk you are willing to carry?
- What type of risks that an investment opportunity will entail?
- What is the cost of investing and what is the expected value of returns?
Concluding thoughts
It is my own personal belief that Australian’s do not have a basic understanding of risk as it pertains to their investments and personal financial situation. I do not consider this to be fault of their own but rather a side-effect of an education system that does not put enough emphasis on finance. I hope that this article has given you an insight into some of the basics of understanding risk in the personal finance field.
Engineer your freedom
References
Chen, J, 2020, Risk, Investopedia, last viewed 5/4/2020 <https://www.investopedia.com/terms/r/risk.asp>