Every investor is faced with risk, and it is often more challenging than not to figure out individual risk tolerances. Warren Buffet said it best when he stated that “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes”. Understanding risk can be complicated, but is vital for every investor, seasoned or new to the game. It is of course much easier to focus on the potential gain with investing, as opposed to the potential loss.
If you want to fully understand risk, you must first differentiate between the major types of risk. While the list seems daunting and never ending, understanding these risks will help you make confident, educated decisions. While this list is not exhaustive it is a good place to start. Generally, you have business, market, default, foreign exchange, inflation, interest rate, liquidity, mortgage opportunity, political and unsystematic risk.
To help you understand what falls into each risk category let’s think of risk in terms of downhill skiing. Should you want to take a smaller risk, or a nice safe green ski run, you would be considering investing within the following category:
- blue chip companies
- well researched public companies
- lots of diversification
- easy to liquidate
This is generally a great place to start, be sure to include lots of diversification in your investments. These are low risk investments that you can easily liquidate. They will not yield you staggering returns (typically average returns), but you can rest easy knowing you will survive the run and make it to the bottom of the hill in one piece. Be careful in this category of some potential distractions. You may discover there are political agendas at play, media negativity bait, confident know-it-alls, distractions, and taxation issues.
Should you be feeling more confident after a few successful green ski runs, you could venture onto a blue run. Slightly more challenging with higher risk and potentially higher gains. These runs include (but not limited to):
- fast growing companies
- private companies
- smaller companies
- direct real estate ownership
- harder to liquidate
These investments might yield you potentially higher than average returns. These ski runs are typically more challenging, but if done correctly, a higher reward. Be cautious of the steep sections or moguls. Those include changing trends, poor investment selection, over concentration, bad luck, no plan, or bad plan. While the blue runs can be exciting and offer a feeling of satisfaction when navigated correctly, they can also be costly. Try not to wipe out!
Now, you’ve had some skillful skiing on the blue runs all day, you are feeling adventurous and brave. You might feel like it’s time to take the chairlift over to the black diamond. Confidence is high (likely from some success in the blue lane), so you feel it might be time for a larger risk. The Black Diamond run is steep, dangerous, exhilarating and often a white-knuckle experience. However, if you have the skills, patience, and are ready to take a higher risk, you may enjoy the benefits of the run. Should you navigate all the potential moguls, treacherous snow conditions, and steep sections you may finish the run feeling very rewarded. These risks come with the highest potential gain and can lead to some excellent results! They include, but not limited to:
- start up companies
- new emerging trends
- new technologies
- speculative investments
- distressed businesses
- long term compounding
- hardest to liquidate
Be very careful on these Black Diamonds, while they seem completely exhilarating, don’t be over-confident. Tread carefully, make smart educated decisions, and ask for advice from a knowledgeable investment advisor (they are your best ski instructor here). Be fully aware of common places to fall; panic buying, panic selling, ignoring human factors, time frame mismatches, and bias.
No matter which run you chose, always be cautious of potential wipe out zones. Dependency, impatience, grandiosity, and inflexibility will cause you to fall every single time. If you want to avoid a yard-sale, make sure you understand how these factors come into play. Commonly, people let their emotions, fear (and fear of missing out), greed, and unrealistic expectations trip them up. Trying to keep emotions in check is not an easy task. It is always recommended that you and your financial advisor discuss some of these issues.
Having an open facilitated discussion about some of these more human responses can lead to safer, better equipped investing. Therefore, it is imperative to have a strong relationship with your investment advisor — they are here to help guide you down the hill, no matter which run you chose. The best ski day will always be one where you try your hand at everything that you feel ready and equipped to ski. Only skiing green runs might lead you to feel unsatisfied at the end of the day, or it might be the perfect day out. Every individual is different, and it is imperative to understand this.