“Risk comes from not knowing what you are doing.” – Warren Buffett
Risk is one of the most misunderstood and misinterpreted words in investing. People assume that risk is always a bad thing when it comes to financial products and has to be avoided at all costs.
“How can I invest my savings to achieve maximum returns with the least amount of risk?”
This is a common question that a lot of new investors ask. The underlying thought process stems from our natural instinct for self-preservation. We all have the tendency to avoid unnecessary risk that will put us or our loved ones in harm’s way. The same instinct kicks in when it comes to making decisions about our financial security.
Risk vs Reward
Avoiding “risk” in financial decisions feels quite natural, doesn't it? It works well in so many other aspects of our lives. For instance, if we drive too fast we risk getting into an accident. The potential benefits and risks of driving recklessly are evident to almost anyone. On the upside, we might experience short-term excitement or reach our destination a few minutes sooner, but the downside is much more drastic in the form of physical and financial loss due to an accident. We are quick to realize that the risks of driving fast clearly outweigh the rewards.
Varying Degrees of Risk
But aren’t there risks even when we drive within the speed limit? What if an out-of-control vehicle rams into us unexpectedly? Does that mean we should stop driving altogether? This is where understanding the possibility of bad outcomes becomes important. The chances of having an accident if you are driving carefully are significantly lower than when you are driving recklessly. Most people choose to undertake the risk involved as the benefits start to outweigh them!
This is a quintessential example of how risk should be considered in terms of investing. There are all kinds of products available in the market with varying amounts of risk. Bank deposits and government-issued bonds are considered risk-free. This means that you are pretty much guaranteed to get your money back and whatever interest or returns have been promised. There is effectively no risk of involved in these products. Drawing a parallel to our driving example, they are the equivalent to sitting at home instead of driving on the road!
Investing in a balanced portfolio of diversified assets such as liquid funds, long-term debt and stocks can be considered as driving within the speed limit. There are some risks involved but the returns that you get substantially outweigh those risks.
Similarly, the rash driving of investing is short-term trading based on stock tips or trading in derivatives like futures and options. You will get an adrenalin rush while doing it and might even have some exciting rides but it will eventually lead to a terrible accident!
Are you in Control?
Just like in the case of driving, you should ask yourself this question while making investing decisions – “Are you in control?”. And the only way to know for sure is by understanding the products and their risk/return characteristics in detail.
Rash drivers often misunderstand the meaning of being in control. They will seldom claim to have lost control when driving fast. But would they be able to avoid an accident if a small child or a stray dog jumped onto the road unexpectedly? This is exactly what happens with people who trade derivates and use stock tips for quick gains. They think they are in control till everything is going as expected. But on rare occasions when there is a surprise event, they end up in terrible accidents.
“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” – Warren Buffett
Consider this simple illustration. Here is the formula for calculating the price of one of the simplest derivatives - a simple call option.
This formula is plugged into a Monte Carlo simulation, which evaluates tens of thousands of different scenarios for the change in stock price to calculate the price of the option. And the risks are calculated by taking first and second-degree derivatives of this equation for different parameters like stock price, interest rate and time.
Can you claim to fully understand the mathematics behind this complex pricing mechanism? Are you aware of how it can be impacted by sudden and unexpected changes in the market? If not, then you can’t claim to be in control when trading these derivatives!
Investing vs Trading
“An important key to investing is to remember that stocks are not lottery tickets.” – Peter Lynch
So how is investing in stocks different from trading futures and options or stock trading? The fundamental difference is their underlying purpose. Investing in good quality companies with solid businesses and long-term growth prospects is an excellent way to put your savings to work. The purpose of doing it is to buy a small part of a healthy business that is expected to grow over the years and give you good returns in the process.
On the other hand, the purpose of trading in derivatives and based on stock tips is making quick returns by trying to predict what's going to happen in the next few days or weeks. And the reason why this is equivalent to gambling is because there is no financial “expert” or “analyst” who has the ability to make those predictions. Most of these so-called experts are just throwing random guesses in the air and their chances of success are typically worse than that of a coin toss!
Taking a Calculated Risk
“Take calculated risks. That is quite different from being rash.” – George S Patton
Like everything else in life, when it comes to investing, there is such a thing as a healthy amount of risk. And the appropriate amount varies from one person to another. By determining your
and carefully formulating a Financial Plan for the future, you can calculate how much risk you should take with your investments. Although you might feel that keeping money in bank deposits is safe, you should realize that you are letting go of a tremendous opportunity by not putting your money to work. Not only that, your money is actually losing its value over time if kept in bank deposits!
The key to successful investing is understanding the risks, having lots of patience and being consistent over a long period of time. Add to that just a little bit of planning and homework, and you have the recipe for an ideal financial outcome.