High risk, high reward
Explaining risk is one of the most curious conversations I have on a regular basis. From an investment standpoint, our brains are hardwired to avoid risk and protect what we have. But without risk, there is no reward. It is important to understand risk, the various risks of investing, and which to mitigate and which to embrace.
As an example, let’s consider the risks of walking to the grocery store. We could get hit by a car. We could get injured on the walk. We could get sunburned. There is a different probability of realizing each risk, and if the probability is low enough, we deem the trip worth the risk. We are willing to take those risks because we are hungry, and the food at the store is the reward.
Also consider that we can take action to change the probability of certain risks. If we choose to wear sunscreen, then we have substantially reduced the risk of getting sunburned. If we choose to walk through neighborhoods rather than along the highway, we reduce the chances of getting hit by a car.
In the investment world, risk is broken down into several different categories, generally classified as either systematic or unsystematic. Systematic risk, also known as market risk, affects everybody in the system. This includes political risks, macroeconomic risks, inflation risk, interest rate risk, currency risk, and liquidity risk.
Unsystematic risk would affect a particular company or industry. Investors are subject to both types of risk, but like the example above, there are some actions that can be taken to mitigate or even eliminate certain risks. Diversification is the primary method by which we mitigate unsystematic risk.
Typically, cash and bank products are perceived as riskless securities. This includes hard currency (cash in hand), checking and savings accounts, money market accounts, and certificates of deposit (CDs). There are some risks present, but they are not systematic risks. The market can fluctuate, and the value of these items will hold steady.
Some people view U.S. Treasury bills, which mature in a year or less, as riskless. While the U.S. Government is perceived as the strongest entity worldwide when it comes to debt repayment, there are many historical examples where governments have been unable to meet their obligations. I would consider T-bills relatively safe, but not riskless.
Words like “safe”, “conservative”, “moderate”, “aggressive”, and “high risk” can be dangerous in the investment world without proper context. I may consider a diversified portfolio of stocks with no bond holdings as aggressive, whereby your definition of the word equates to Bitcoin.
For most financial planners, those labels apply to systematic risks. Unsystematic risk is reduced through diversification, either in multiple holdings or the use of mutual funds and exchange-traded funds.
If we broadly categorize investments into three groups - cash, bonds, and stocks - then we can manipulate the percentage of each in order to develop portfolios that are conservative, moderate, or even aggressive.
That brings us to high risk. When is the time right to take high risk? I would say that you can take high risk with any assets you have above and beyond those that you need to survive for the rest of your life. In other words, assume your mortgage is paid off, your retirement pension and social security far exceed that which you need to survive, and you have some surplus assets that you could lose without jeopardizing your survival. At that point, it can make sense to concentrate in either single stocks or single industries in order to attempt to drive higher returns.