What Is Risk?

"Risk comes from not knowing what you are doing." - Warren Buffett

When it comes to investing, the word "risk" has become meaningless. It means different things to different people, and without a common understanding, we can't have a productive conversation about how to measure and reduce or eliminate it.

The media talks about "risk on, risk off", we get told that shares are "risky" and that bonds are "safe". These are uninformed views of risk. As a long-term lifetime investor, you deserve to have an informed view of true investment risk.

The following analogies are an attempt to codify a new way of understanding the three different types of risk we face when investing for the future.

The Turkey, The Ice Sculpture & The Rollercoaster

These three characters play leading roles in this attempt to reframe the "risk" conversation. The key question to ask is, "What exactly am I risking?".

As you'll learn from the three flavours of risk described below, it's not possible to avoid all risk. You just get to choose the type you are happy to dance with.

Loss of Capital Risk

The first flavour of risk is the risk of permanent capital loss - a valid concern for many. The best way to expose yourself to this risk is to invest in "what's working now", the latest investment fads. If it seems too good to be true, it probably is.

Like the turkey that gets treated like royalty, only to have a rude awakening on Christmas eve, the investment fads of the day work until they don't. You do not want your family's life savings to be invested in anything where there is a non-trivial possibility of permanent loss of capital.

If you invest in a single share, there is a very real chance that you could lose your capital forever. A diversified portfolio of the great companies of the world - there's no evidence to suggest that a permanent loss of capital is a possibility.

Inflation Risk

As we demonstrate in these monthly newsletters, inflation is the slow, silent, deadly financial killer. It slowly erodes your capital over time, eating into your purchasing power.

Like the swan ice sculpture at a wedding that looks pristine before the ceremony but is hardly recognisable by the time the groom fumbles through his speech, some assets appear to be safe. However, when analysing its ability to protect you from inflation over multiple decades, the appeal starts to fade. Think of the government bonds that we are told are "safe", and then compare their ability to outpace inflation to the remarkable real returns of the great companies of the world.

How are you positioned against the risk of inflation?

Volatility Risk

This is the flavour of risk that most people are thinking of when they use the word "risk". However, we argue that this is the least dangerous flavour of risk.

Like the rollercoaster ride that makes you think you are never going to step safely onto land again, investment volatility convinces the uninformed investor that what they are experiencing is "risky". An informed understanding of the market will help you to understand that fluctuating prices are a feature, not a bug, of the investment world.

"The stock market is a device for transferring money from the impatient to the patient.", as Warren Buffett said.

In the same way that it would be a terrible idea to get off the rollercoaster mid-ride, so it is unwise to give up on an investment strategy and portfolio that has been designed for your lifelong aspirations, just because its value is fluctuating in the short term.

What's Your Flavour?

The reality of the investment market is that you cannot avoid all three risks, you have to choose one.

If you want to avoid permanent capital losses and you want to keep ahead of inflation, then you are going to need to learn to dance with the risk of volatility. It's the price of admission for those serious about accumulating long-term wealth.