Newspaper article Sarasota Herald Tribune

There Are Risks, and There Are Ways to Control Them

Newspaper article Sarasota Herald Tribune

There Are Risks, and There Are Ways to Control Them

Article excerpt

TODAY, I'M GOING TO COMMENT on a concept beloved by financial advisers and disdained by many investors: risk.

The importance of managing risk is something investors give lip service to, but too few go beyond that.

One reason it's disdained by investors is it's painful to consider its implications -- something might go wrong with an investment. It's more pleasurable to consider the riches an investment might bestow than the pain it will inflict if it goes awry. Another reason is that it's quite easy to talk about in a qualitative sense but more difficult to quantify.

Advisers concentrate on risk control because it's their job. Many advisers would agree their first priority is to manage risk, not to earn the highest returns.

Qualitatively, the notion of risk appears quite simple -- failing to meet an investor's goals.

Transforming that into something quantitative and actionable is where complications arise.

To many investors, this notion of risk translates into something quite simple -- losing money in an investment. For several reasons, however, this is too simplistic.

First, there is no timeframe. Since today's stock price has little to do with tomorrow's, it's not unlikely that about half of an investor's stocks purchased today will be worth less tomorrow. To be reasonably useful, "losing money" needs to be coupled with a timeframe.

Second, even the most naive investor realizes that it's not likely that every investment will produce a positive return over its intended timeframe, or "holding period."

Thus, for the concept of risk to be truly useful, it needs to be related to the behavior of the investor's entire portfolio.

This results in a slight modification of our original definition. Risk is the chance of a portfolio failing to meet an investor's return goals for a specific timeframe.

The key question is how do we minimize this chance?

To do this, we deal with the two main components of portfolio risk: "systematic risk" and "unsystematic risk," also known as "security specific risk."

The former is the risk taken on by, for example, being in the stock market rather than in cash.

The stock market is inherently unpredictable and this results in natural volatility that an investor must accept. …

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