What is risk?

Investing

What is risk?

Eric DunavantSeptember 23, 2019

How do you define the word risk? For me, risk is jumping out of a perfectly good airplane. Twenty-five years ago, I thought risk was asking out the cute brunette, who was on a date with a friend of mine, while I crashed their dinner.  (She’s still married to me in case you are wondering.)

The word risk seems to conjure up a “worst case scenario” in most minds.  For this reason, I’ve always hated when people ask how much RISK I would like to have in an investment portfolio.  If we are talking about “worst case scenarios” then my preference would be NONE!

When making decisions to invest my hard-earned money, my decisions involve my heart as much as they involve my head.  For this reason, I think the words we use matter.  In my experience, no one wants to go through RISK, but maybe we’ve simply been exposed to the wrong word.  For that reason, I would like to introduce you to a better word that can help frame your perspective:

Volatile [vol-uh-til]  (adjective) – tending to fluctuate sharply and regularly.

Fluctuations and sharp moves don’t sound fun either, until you realize the fluctuations could be up as much or more than they could be down. It’s rare for the loud mouths in the industry to talk about upside moves in investments as “volatility,” when in fact, that is exactly what it is.

Through a simple change in language, we begin to recognize a well-diversified portfolio, made up of great companies in the US and around the world, doesn’t have risk, but it does have volatility. What history reveals is that a diversified portfolio has never experienced the “worst case scenario” for those who stayed with their long term plans.  The past doesn’t necessarily tell us about the future, but it often does rhyme.

With that in mind, I wanted to share three factors you should consider when you start adding these great US and international companies to your portfolio.

First, you need to know the higher the volatility of an investment, the higher its potential return. The greatest example of this is represented in the historical returns of the markets. Over the last 80 years, small companies have averaged around 12% per year, large companies have averaged about 10% per year, while bonds have averaged only 6%.[1] These numbers don’t change much when you shorten the periods down to 10 or 20 years, even after the market crashes of 2001 and 2008.

What you need to understand is that each one of those numbers is an average. Think of volatility like a roller coaster, the roller coaster small companies ride in order to achieve a 12% annual return is only fun for those that are adventurous.

The hard truth for every investor is that the only way to get a higher return is to be willing to tolerate higher volatility. Without a willingness to accept the temporary losses that comes with volatile investments, you will never have the opportunity to receive their long‑term results.

Second, the cost of investing in any portfolio is sitting through the declines. Despite our desire to the contrary, the stock market does not always go up. There are periods where it goes down, sometimes longer and deeper than most of us wish.

However, if you look at the long‑term trend of the market, it looks a lot like climbing a mountain. There are times where you go down in order to make your next approach up. I encourage you to focus on investing as a journey and not an overnight trip. Sitting comfortably through the declines, will give you an appreciation for the experience, but ultimately will give you the greatest reward.

Third, and as of today most importantly, the advance has been permanent while the declines are only temporary.

Even the recessions of 1929 – 1930 and 2007 – 2008, ended and went on to see new highs. Many people fail to recognize that the decline is just a temporary situation.

If you own the best and the brightest companies in the US and around the world, you know they will be doing everything in their power to maintain and grow profitability despite the economic environment.  It may take some time, but long-term, their ultimate goal is to create returns for shareholders.  If you bought the right companies, give them time to navigate challenging environments.

Good investing is not easy, but the rewards are worth it. It will require you to fight every emotion you may have, but over time, the best investors begin to recognize and appreciate volatility as a gift.

At Paradiem, we believe that the greatest risk to your investment decisions is the never-ending rising cost of living.  Too many families face a “worst case scenario” of running out of money or losing purchasing power because they misunderstand the power of excellent investing. The best vehicle we have found to overcome this risk lies in owning the best companies who are pursuing excellence for their investors, employees and consumers.  If you would like more information on “Excellent Investing” email info@paradiem.org with the subject “Excellent” or give us a call at (985) 727-0770.

 

[1] Average stock returns:  Ibbotson SBBI (Stocks, Bonds, Bills and Inflation 1926 – 2017), From Stocks, Bonds, Bills and Inflation (SBBI) Yearbook, By Roger G Ibbotson and Rex Sinquefield, updated annually

 

About the Author

Eric DunavantEric is the president of Paradiem, a man devoted to God and the advancement of His Kingdom.

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