More Can Happen Than Will HappenSubmitted by Trace Wealth Advisors on July 15th, 2019
I spend a lot of time looking over investment ideas and trying to match up my clients’ goals with the easiest ways to get there…everyone wants the best possible return with the least amount of risk. Some have even been bold enough to ask me to find them high return investments with NO risk (please note: this is impossible unless you consider T-bills a “high return investment.” I don’t care how great your cousin’s real estate acumen is or how well your neighbor trades oil futures…there is no free lunch in investing.)
Risk is, at its core, the idea that more things can happen than will happen. It is everpresent in the world around us.
In the rear-view mirror, risk is finite, certain, and even somewhat intuitive. Upon maturity of an investment, you can be certain of the return you received and the various risks that came to fruition. Using 20/20 hindsight, you can look at all of these risks and easily explain why each one took place and how the investment responded as a result.
Risk in the future, however, is an entirely different ballgame. I can show you statistical studies of what’s happened historically or what I think may happen, but I can’t say with any certainty if these figures will even be remotely reliable when forecasting what will actually happen.
So, as investors interested in the future and not the past, how are we to think about and visualize risk and its impact on our investments? Well, it’s really fairly simple. Here is a picture of how most people visualize risk (as shown by the efficient frontier):
Each point along the continuum has what appears to be a fixed level of risk. In short, the more risk I take, the higher the return I receive…pretty instinctive and easy to put into action. The problem with visualizing risk in this way is that risk isn’t a fixed figure necessarily, but rather a range of possible outcomes.
My opinion is that investors should really view risk as something that looks more like this:
That is to say, for each given level of risk, there are a bunch of possible outcomes. These possible outcomes widen as the potential returns grow larger, bringing with them (you guessed it) more risk!
And that, dear readers, is the simplest way to visualize risk.