Investment Risk is the chance that outcome of an investment is different from what was expected from it. Risk-Return relationship is one of the fundamental laws of finance. There is a positive correlation between the ‘amount of risk’ & the ‘potential for return’. Risk does not always translate into profit, the connection between the two is just that of a higher probability. A higher risk investment has higher potential for positive (profit) as well as negative return (loss).

• In the short run – Risk is in volatility of price of underlying asset i.e., how much it can rise or fall, given a period of time.

• In the long run – Risk resides more in loss of purchasing power of money than in volatility of price of asset.

Relating to Risk

Risk is a fact of life for investors. It cannot be avoided but one need not blindly submit to it, either. An investment that has the chance of a higher return is likely to have higher risk but high risk by itself does not mean higher returns. The risk-return tradeoff does not completely apply to an investment portfolio because investor’s behavioral impulses vis-a-vis risk continue to evolve with time. It is for this reason that temperament is considered so crucial to successful investing.

Risk Taking Behavior is determined by

• Motivation behind investment decision – ‘not losing money’ / ‘making money’
• Emotional State – fear / greed
• State of Market – Bear market increases risk aversion / Bull markets increases risk taking.
• Personal Finances – Improved finances & Wealth effect increases risk taking.  

The kind of relationship an investor has with risk is largely determined by his/her decision-making biases & psychological weaknesses. Data based or factual assessment of risk is often overshadowed by traits such as

• Overconfidence that one knows more than the market,
• Confirmation bias that only looks at supporting data but ignores analysis that goes against investment hypothesis,
• Loss aversion that takes on long term risk of poor returns while trying to avoid short term risk of volatility,
• Regret of having missed opportunities could drive investor to take on more than desirable risk.

Recognition of one’s relation with risk could help set guardrails for risk mitigation.

Portfolio Risk

Portfolio risk is a chance that the combination of assets held by you, fail to meet financial objectives. Each investment within a portfolio carries its own risk – but holding a combination of investments that do not depend on the same circumstances to return a profit – reduces risk to achieving the financial objective. Risks only get minimized & are not eliminated entirely. Risk could present itself in various ways.

Mother of all Risks – There is not enough money to fund the overarching financial objective of retirement or that post-retirement there is no money left.

Risk of Asset Mix – The return produced by combination of assets in a portfolio may be so volatile that investor shifts to an ultra-conservative portfolio at an inopportune time or that volatility causes value of the asset-mix to go sharply into negative zone just when investor is close to needing the money, with little time left to possibly recover the losses.

Inflation Risk – Asset mix heavily skewed towards debt runs the risk of declining purchasing power over long term.

Cause Concentration Risk – Outcomes responding to the same cause, have same risk even if investment is held over different asset classes. For example, (a) lower rated debt & equity react in same way to health of economy (slower GDP leads to losses in both – even if to different degree), (b) employment in Information Technology (IT) startup & IT dominated equity investment (happenings in IT sector would lead to same outcome).

Portfolio Concentration Risk – Investment in too few stocks (even if high quality) or in few industries (even if number of stocks is large) makes outcome too much exposed to single factor. Cyclical factors or technological shifts could expose portfolio to drastic volatility.

Behavior Risk – Investor is the biggest risk to his / her own portfolio because falling prey to emotions of fear & greed, investment biases & investment indiscipline seriously undermines the outcomes. Chasing ‘returns’ in greed & seeking ‘safety’ in fear, has the same impact on an investment portfolio.

Portfolio Positioning

An investor seeks the most acceptable trade-off between risk & reward, while investing in a collection of assets with different weights and that is done in context of one’s

• Risk Capacity – Ability to take risks. Financial goals & time horizon for each of them, helps draw parameters for risk capacity.

• Risk Tolerance – Ability to withstand those fluctuations (variability of returns) without having to change the plans. It is the ‘anxiety-adrenaline’ framework of an investor, beyond which an investor is prone to making ill-advised moves.

• Risk Appetite – Willingness to take risk. Not a measure of how much risk we can take. It is an appreciation of how much risk to take i.e., Risk Appetite = Risk Awareness.

What to do in case of Mismatch between Risk Capacity & Risk Tolerance?

High Risk Capacity – but – Below Average Risk Tolerance – Employing hybrid mutual funds as core holdings &/or holding equity-based portfolio with diversified set of more conservative securities can tamp down volatility without entirely sacrificing the upside potential of equity.

High Risk Capacity – but – Low Risk Tolerance – Employing value-oriented & Equity-Savings mutual fund portfolios that primarily seek to protect the downside.

Low Risk Capacity – but – High Risk Tolerance – Bucket Strategy that segments the portfolio by time horizon, would earmark short-term debt for short to medium term goals & allow an investor to safely invest in more volatile assets. 

Risk Averse investors – Practice good portfolio hygiene by focusing on quality of the portfolio composition. Also, employ disciplined rebalancing to remain confident about the portfolio positioning vis-à-vis the time horizon.