For each individual, the word “risk” evokes a different image or experience. A person’s perception of risk can be shaped by past experiences, recent stories in the media, the latest investment-related study, and incidents recounted by friends and associates. Too often, it’s these factors and not actual probabilities that shape an individual’s expectations for the future.
“Recency” is the tendency to place more weight or significance on recent and current events than on past events. From a recency perspective, when the market is going up, investors project that it’s going to keep going up, and therefore invest more money. When the market is declining, investors don’t invest — or they sell — because they project that the market is going to keep declining.
In the excitement of sustained bull markets, such as the exceptionally strong bull market of the late 1990s, investors become overly optimistic and underestimate or ignore risk altogether. Ironically, at times like those, many investors view the level of risk as being very low. Actually, it’s the opposite. It’s only when things go badly that investors realize they should be thinking about risk. Sometimes, they discover they are not as willing to take on as much risk as they thought.
During bear markets, investors see the market as highly risky when, in fact, it has much less risk than at the top of a bull market. Think back to the Financial Crisis in the first week of October 2008, when the major market indexes were all down approximately 40% for the year. At that time, the perception of the market was that it was extremely risky–riskier than it was at the beginning of the year when it was approximately 67% higher.
When considering risk and return, it’s usually return that gets attention from most investors. And why not? Return is the fun part of investing. But controlling and managing risk is the key to good long-term investment results.
To understand the importance of controlling and managing risk, let’s look at the math involved when figuring out how much we need to gain to break even after an investment falls in price. A 50% loss would require a 100% gain to get back to even. A 95% loss, as experienced by some tech stocks between 2000 and 2002, would require a gain of 1,900% to break even.
A limited or distorted understanding of risk can result in either 1) a portfolio containing risk that exceeds your risk tolerance level, or 2) a portfolio that reflects extreme measures to minimize risk (such as keeping your money in cash). A portfolio that does not include enough risk may generate a return that is insufficient to meet your financial goals.
Remember that risk and return should always be considered together. When an Azzad advisor works with you to put together your portfolio, they don’t make recommendations based on one variable without considering the other.
If one investment has a better return than another, then the advisor will still evaluate the amount of risk taken to achieve the returns. It is possible, on a risk-adjusted basis, that they might choose Investment A with an expected 8% return over Investment B with a 10% expected return. Why?
Well, based on the return alone, investors would choose Investment B. However, it’s possible that Investment B has more risk than Investment A. Let’s take an extremely hypothetical example. Assume that Investment A is a blue-chip U.S. company and Investment B is a North Korean cryptocurrency firm. Is the additional risk of Investment B balanced by the 2% additional return? Nope. This is why risk has to be assessed in conjunction with the expected return of an investment.
By the same token, you should not consider risk by itself when thinking about making an investment. An investor should never choose the more preferable risk level without looking at the return that might be achieved for the level of risk taken. To receive a higher return, an investor must almost always take greater risk. That does not, however, indicate that taking higher risks will automatically generate higher returns.
The key to building wealth is to take intelligent, informed risks. Risk-adjusted return is important. Don’t forget that. And let us help you figure out what makes sense for you before you take the plunge.