“Think ‘investment risk,’ and what pops into your mind? For many, it’s ‘volatility.’
It’s true, volatility is a significant risk, especially over short periods.
Watching your investments fluctuate wildly can be nerve-wracking. But it’s not the only risk out there.
Volatility: A Double-Edged Sword
Yes, volatility can be startling. Imagine seeing a 20% drop in your portfolio during a market correction. Or worse, a 30-40% plunge in a bear market.
It’s tough, but remember, finance theory and history suggest that enduring this volatility can lead to greater rewards in the long run, compared to less volatile assets.
The Misunderstood Interest Rate Risk
Now, let’s talk about bonds.
Often seen as the ‘safer’ choice, they come with their own set of risks.
Take interest rate risk, for example. It’s the risk that changing interest rates will affect your returns. If you’re rolling over a bond in a low-interest environment, you might have to settle for a lower yield or take on more risk.
…And if interest rates rise, the value of your current bonds can decrease significantly. This is a risk you can’t afford to overlook.
Beyond Volatility: Other Risks
But wait, there’s more.
Inflation risk, political risk, exchange rate risk, liquidity risk – the list goes on.
Focusing solely on volatility means ignoring these other crucial factors.
The Food Portfolio Analogy
In my MBA, I collaborated on a paper comparing investment portfolios to food choices.
Just like with food, where people want taste, nutrition, and prestige, investors want multiple things from their investments.
They often focus on what they’re not getting at a particular moment, like missing out on gains during a bull market.
This leads to a unique kind of risk – opportunity cost.
Opportunity Cost: The Hidden Risk
Opportunity cost is the risk of missing out on higher returns by being too conservative, especially if you have a long investment horizon. Over time, this can lead to significant shortfalls in your portfolio, impacting your retirement plans and lifestyle. It’s a risk that often goes unnoticed until it’s too late.
Conclusion: A Balanced View of Risk
In conclusion, while volatility is a key risk, it’s not the only one. For long-term investors, not embracing enough volatility – or opportunity risk – can be even more damaging.
Remember, successful investing requires a balanced view of all potential risks, not just the most obvious ones.