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Components of Investment Risk

The risk/reward relationship is likely the most fundamental concept of finance. But “risk” is such a vague term that I think it can be helpful to break it down into more tangible components.

Time as a Component of Risk

When it comes to money, time is a key ingredient. It can take an otherwise very risky investment and make it significantly less risky–possibly even conservative.

For example, a friend of mine is buying a condo in Manhattan. While prices have come down recently, they are still astronomically high. My buddy is worried about buying this condo because he fears that prices might drop. If he does buy the condo, the reward is pride of ownership and (possibly) a good long-term investment. But the risk that he’s thinking about is the risk of overpaying for his pad.

Why is he thinking about that?

He’s completely forgotten about the element of time. He’s not going to sell his condo this year or next. He’s not going to fund his down payment by going into credit card debt. He’s got the cash just sitting there. And the odds are, he’ll hold on to that place for the next 20 years. It doesn’t matter what the price of the condo does over the next few years because that will have no impact on him.

When you think about risk and reward, don’t forget about time. Consider your risk over your intended or likely time frame.

Probability of Loss

The next component of risk is probability. Yes, it’s important to understand what a bad outcome might look like, but in order to make a good decision, we have to be mindful of the chances of something catastrophic happening.

Think about driving your car. There is always the possibility of getting into a terrible accident when you get into an automobile. But the odds of a catastrophic accident are so remote that most people don’t have a problem getting into a car and driving downtown.

Investments are no different. When you make an investment, there are always risks. You can take steps to reduce those risks, but you can never eliminate them. Because risk exists, does that mean you shouldn’t take action? It may…if the probability of that bad outcome is significant. But if the probability is very low, you (usually) shouldn’t let it stop you.

Magnitude of Loss

The final component of risk is magnitude. The odds of something happening might be very low, but the magnitude of the consequence might be so great that you still can’t take the chance.

Consider robbing a bank: Even if you have what appears to be the perfect plan, it’s a bad move. The idea of going to jail is so repulsive that it makes the proposition a non-starter. In this case, the magnitude of the consequence is so high that it almost doesn’t matter that the odds of experiencing that negative outcome are low.

Similarly, even if you have a “sure thing” investment, it’s still important to diversify. If you put everything into one ostensibly low-risk investment and that one-in-a-million bad outcome occurs, your life savings will be history, and you won’t have enough money to retire.

When considering magnitude of risk, rather than thinking in terms of dollars, it can be helpful to think in terms of impact. For example, Bill Gates can lose $10,000, and it won’t impact him at all. He can still live on any island he likes. You might also be able to lose $10,000 without it having a huge impact on your life. But somebody struggling with debt can’t afford that risk. Such a loss would be a game-changer and, therefore, not an acceptable proposition.

In summary, when investing, you need to understand what you are risking, how likely that risk is to appear, and how the magnitude and probability of that risk change over time.

About the author: Neal Frankle is a Certified Financial Planner in Los Angeles and runs Wealth Pilgrim.com–a personal finance blog for people interested in making smart decisions about their money.

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Comments

  1. If by “risk,” you mean the probability and/or magnitude of undesirable outcomes, than an investor’s risk increases with time because more time allows for a wider range of potential outcomes. This is especially important when comparing alternatives. Time can allow for a greater deviation in either direction between the ROI on a Manhattan condo compared to any other investment opportunity, even those deemed to have similar “risk.” The conclusion that time mitigates investment risk is usually supported by illustrating that the range of standard deviations of investment returns narrow as the time period increases; however, this is not relevant to an investor’s invested dollars. This is often referred to as the “fallacy of time diversification.” (Google it to read more about it.) In your example about the Manhattan condo, risk is being mitigated by a low need for liquidity, not time.

  2. I also disagree with the Manhattan condo example. The risk of overpaying is real and it can’t be mitigated by holding the condo for a long time. If person A buys now and person B buys next year at a lower price, person B can invest the savings in something else. Person B is better off than person A no matter how long person A holds the condo.

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