Risk is the one of the most misunderstood terms in investing. Most people can gauge their own risk appetite. They either like to take risk or not. If you are a risk taker, the next step is determining your risk tolerance. This is the degree of potential investment loss for a given level of return that you would like to achieve. The commonly used risk metric to calculate this number into a percentage is standard deviation. But just to warn you, this calculation has proven to be a terrible way to determine risk. For instance, back in 2008-2009 when markets collapsed, the standard deviation of the S&P 500 jumped to one of the highest points on record, but this turned out to be one of the best buying opportunities of a lifetime.
The risk that is most important to investors is downside risk. Warren Buffett has become one of the richest men in the world by understanding this type of risk. It is not a calculation. He measures the intrinsic value (true worth) of a business and assumes a margin of safety. Simply, he wants to know the potential downside if he is incorrect. His goal is to keep his losses small if he misjudges the value of a business.
As an insurance operator, he is constantly calculating his risk threshold. This happens to be the number that I’m most interested in understanding for my clients. As Buffett’s risk threshold has grown, so has his ability to take bigger bets. He believes in concentrating his investments because good ideas are hard to find. Buffett would prefer buying a company with a very high standard deviation that has lost value for non-economic reasons. A company’s ability to turn a consistent profit with minimal capital expenditures is his ideal investment.
The first step to create an appropriate asset allocation is to understand the investors risk threshold. What is the actual amount that an investor could lose without incurring a budget shortfall? This is similar to how Buffett runs his insurance business. If there is a loss in his business, he maintains a 20% cash allocation for liquidity purposes. The excess cash also puts him in an opportunistic position to take advantage of those investors that used standard deviation to calculate their risk tolerance.
Risk is a moving target as personal situations change and markets fluctuate. No two people will have the same risk threshold, but they may have the same risk appetite and risk tolerance. Having a retirement plan is essential to measuring your risk budget. Without proper goal setting it is impossible to understand your risk budget. In this volatile market, there will potentially be better opportunities ahead, if you understand these different types of risk.
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