Understanding risks associated with any investment decision in one of the core principles of finance. One could argue that there is more than one way of looking at risk and how you look at it can possibly tell a lot about your investing approach. Here are a couple of ways to look at risk.
Understanding the 3 sides of risk
Morgan Housel, the author of Psychology of Money, gave a very clear insight on the 3 important sides to risk.
- The odds of a risky event occurring
- The average consequence of a risky event occurring
- The tail-end consequences of a risky event occurring
In investing, the average consequences of risk are the ones which make up most of the daily news. But the tail-end consequences of risk, like a pandemic, are what end up being the topics of history books. The low probability, high impact events are what end up mattering the most.
The biggest risks are usually the ones you don’t see
Back in the early 2020, investors might have argued that the biggest risk to global financial markets might be the US presidential elections or a trade war, while many investors in Croatia might have debated whether tourism activity has already peaked and if there is still room for growth. Some of the mentioned perceived risks in the market were debated year after year, while in hindsight none of these were closely as important as the pandemic, which virtually no one saw coming.
In other words, the biggest economic risks are usually to ones you do not see, and if no one is talking about such risks most are not prepared for it. Therefore, the harm of such risks will be augmented when they occur. Paying attention to risks are crucial in investing, but what we do not see will likely be more significant than all the known (expected) risks combined. History is full of such events.
How you perceive risk depends on your past experience
If you invested in the equity market for the first time in your life just before the housing bubble burst, chances are you might have a different perception of riskiness of investing in equities compared to someone who had invested in S&P 500 during the 1990s when the index returned as much as 300% in a decade. The same goes for other economic or life phenomena. Those who lived in Yugoslavia during hyperinflation times arguably perceive the risk of inflation to be much higher than those who had never lived through such a period. This does not surprise, given that adversity shakes peoples believes and tends to leave them pessimistic. Although being risk averse is definitely not a bad trait, fully avoiding risk could be sometimes even more damaging. As an example, driving by car surged after 9/11 attacks, as more people avoided air travel. This in turn led to more excess car deaths than casualties from the actual terrorist attacks. A similar case could be made for finance and equity investing. By taking no risk with your money (never investing it), thinking that you have fully avoided risk, you might end up being worse off.
Risk is the probability of an event ending with an unfavorable result
To expand on the last sentence, one could argue that risk is the probability of an event ending with an unfavorable result.
If you decide to store your money in a mattress for a longer period of time, it is almost inevitable that inflation will erode your purchasing power. Having such a definition in mind, one could than argue that the aforementioned decision with your money is not risk free at all, but actually very risky, as you can almost certainly be sure that such a decision will end in an unfavorable result. To put things into a perspective, from 2002 – 2020, Croatian Kuna lost 38% of its value. Meanwhile, in a similar period (available data) CROBEX showed a total return of 123%, despite the 2008 crisis, Agrokor and the pandemic. This does not necessarily mean that one should invest all of his cash into equites, but that one should be aware that risk avoidance (not investing) does come at a cost as well. When looking at the deposits of Croatian households, which are equivalent to roughly 2 market caps of the entire ZSE, one could argue that most do not necessarily think this way, given their low exposure to any other financial asset.
It is not easy to estimate how you will react to risk
All of the above stated is possibly old news to most, but the reason why it is important to be aware of the above mentioned is that it is not as easy to grasp how you will react to risk when it actually occurs. One way to look at a market dip is to view it as an opportunity for possibly cheaper valuations and, therefore, higher future expected returns. But of course, that is not the case for many retail investors, as the mentioned is easier said than done. That can debatably be attributed to the fact that people are more fearful when their investments are dropping and greedier when they are surging. This is one of the reasons why so many retail investors end up underperforming. Surely, they know that one should not buy high and sell low, but this tends to be the case in almost every crisis. The same thing happened in Croatia during the outbreak of the pandemic. As a reminder, back in March of 2020, NAV of all Croatian UCITS funds dropped by almost a third. However, in that period (21 Feb – 24 Mar), 86.1% of the mentioned decrease could be attributed to withdrawals from the funds, while only 13.9% can be attributed to a change in value of assets in which the funds invest.