The Good, the Bad and the Necessity of Risk
by Eric Marshall, CFA, on January 12, 2023
In the world of investing, “risk” is predominantly viewed as a dirty word. Although it seems natural for investors to think of risk in negative terms, as something to be avoided, we contend it is more appropriate to view risk as a normal function of capitalism that is inseparable from the performance of investment returns. As a result, risk should not be avoided, but instead thoughtfully managed to maximize desired investment returns within the context of a portfolio’s overall objective. In this paper we will discuss multiple perspectives on indentifying, measuring, appropriating, and monitoring various types of investment risk.
The Role of Risk
Risk is part of just about every worthwhile human endeavor. Although many risks in our everyday activities such as driving to work may seem trivial, engaging in and managing the realities of risk is a natural human behavior. Furthermore, history has demonstrated that most major advancements in civilization involved someone taking a calculated risk. Whether it was ancient explorers sailing the seas to discover new lands or the Apollo Space Program, most achievements are attained by calculating and managing risks.
In finance, the basic definition of risk is simply the probability that an investment’s return will be less than an investor’s expected or desired return. Of course, investment risks can take many different forms, which may include broad systematic risks such as geopolitical, economic, foreign currency, and interest rate risks. An investment’s sensitivity to these market risks are commonly indentified and measured using beta. Investment risks also include those that are unique to an individual investment such as credit, operating, competitive, and liquidity risks. Some of these risks are more difficult to indentify and manage than others. In active portfolio management, risks that can be managed to optimize relative returns and add alpha (excess returns) to a portfolio are primarily unique risks, which are also known as nonsystematic risks. Sizing up these unique or company specific risks among publicly traded companies requires time-intensive research that involves the detailed analysis of a company’s business model, profit outlook, capital availability, competitive landscape, and balance sheet. After undergoing such due diligence, a company’s relative upside potential to the market’s overall return should be weighed against downside risks.
Investors should always consider both the positive and negative outcomes of taking any investment risk. This distinction is illustrated in the Chinese symbol for risk: