Too Much Investment Risk
By Brad Thomason CPA
3/14/2015
Investment risk is something we all sort of know is out there, but not something that always get the attention it should. We assume – rightly – that in an investment situation there’s going to be some risk. But the details are harder. We talk in terms of higher risk or lower risk, but specific measurements are tough to define. And for that matter what does risk even mean? Is it the chance that something bad is going to happen, or something else? What bad thing; and what’s causing it? Am I looking at getting a yield that’s less than I wanted, or am I facing a loss of my money?
All of these lead to a tendency to sort of wave at risk in acknowledgment of its presence, but not really dig deeper or even pay it that much attention when making investment decisions.
When you meet with a stock broker you’ll get asked what kind of risk you are comfortable with. They are looking for you to say “low” or “high” or something like that. The reason they ask you that question is because they have to. It’s known as a “suitability” question, and by law they have to get you to chime in on what you are comfortable with before they can conclude that the thing they are suggesting is a suitable investment.
But there is some debate over just how useful the question really is. First, there is the matter that terms like low and high are so hopelessly ambiguous that they might not tell us much. Now in fairness, in the case that someone says low, then you can get some benefit in the form of eliminating some of the possible investments. But if the client says moderate or high, functionally speaking that translates to pretty much anything goes.
Second though is the question of whether or not your tolerance matters in the first place. Let me explain.
Suppose you are nearing or already in retirement and you already have what you need to live the life you want. When I meet with people in this situation I counsel them to not risk their savings trying to get a lot of additional growth that they may not even need. The rationale is that they’ve already won. So the focus needs to be on protecting the capital and trying to use it to earn a reasonable return versus jeopardizing the win and suffering a loss at the worst possible point in life (since your opportunities for replacing that capital are heavily constrained if you aren’t working anymore).
In such a situation, I would argue, it doesn’t matter if you can live with the extra risk or not. What matters is you don’t need to take it on in the first place. Those who have a growth need may not have any choice but to take on risk. But if that’s not you, why take on the risk even if you have the nerves for it?
In practice though, we see people routinely taking on more risk than is necessary for their situation. Oaktree Capital’s chairman Howard Marks was recently interviewed in Fortune, and he summed it up like this: “Maybe they don’t think it or say it explicitly, but I think [investors] are saying, ‘If I can’t get 8% safely, I’ll get 8% unsafely.’ “
Investors need to know that there are a number of in-between options. By that I mean things which pay more than CDs and Treasuries, but without the same level of risk associated with a stock or stock fund portfolio. It doesn’t have to be an either/or decision, and investors who take the time to learn about all of the alternatives stand a better chance of having a portfolio tailored to their needs, and one in which high risk is not an unintended side effect.