Ask most ordinary people what they understand by risk in the concept of investment and their immediate response is likely to be that it is about the potential for loss. That is fair enough, but you have to go on from there to break it down into further components - what is the probability of losing money, and what is the likely scale of that loss?
We all have different tolerances for both parts of that equation. But before you even start thinking about that, you have to ask a more fundamental question - whether the loss that is being talked about is a realised or a prospective loss. The distinction between realised and unrealised losses is fundamental to making sense of the choices investors face - and to what kind of risk they should actually be taking on.
Consider this example. Three of the most successful investors of the modern age have been Warren Buffett, Sir John Templeton and (in this country) Anthony Bolton. Between them they have well over 140 years of experience of managing money for other people. All three have beaten their respective benchmarks by thumping margins over long periods of time and, thanks to the wonders of compounding, have produced huge gains for their investors.
Bolton, for example, has grown the value of his fund 100-fold over the past 26 years, while those who invested in Buffett's original investment partnership in 1957 and followed him all the way through to the present day have more than $400m for every $10,000 they invested at the outset.
Investors who put money into the Templeton Growth Fund when it first launched in 1954 and kept it there for the entire 40 years that Sir John was overseeing it would have ended with a sum four times as great in real terms as an equivalent investment in the world equity market index.
All three men have achieved their gains by investing primarily in the stock market, which is, as we all know, the riskiest of the mainstream asset classes, which in turn is why it has to produce higher returns. But then, consider this other fact: in all their 140 combined years of experience, equivalent to 1,680 distinct 60-month holding periods, there are barely any five-year periods in which their funds have failed to produce a positive return for investors. In Sir John's case, there was not one five-year period in which his fund failed to produce a positive real return; that is, both before and after taking account of inflation.
It turns out therefore that any money investors put with these three men over the past half-century has turned out to be essentially risk-free, in the sense that the capital was never at risk in nominal terms, provided the money was invested for a minimum of five years. It was very rarely even at risk in real terms (after inflation). Combine that with the exceptional returns, and you have what is in effect the Holy Grail of investment, a potent combination of high returns and zero risk.
Yet the paradox is that the majority of ordinary investors, and many investment institutions too, would never even think of putting their money with any of Buffett, Templeton or Bolton, on the grounds that equity investment is too risky - which is exactly what happens when you fail to distinguish between volatility and risk of loss.
Standard financial theory requires investors to use the volatility, or more precisely the standard deviation of returns, as their main measure of risk, and many professional institutions are explicitly barred from investing in assets whose volatility exceeds a certain minimum level.
There is some logic in this approach, as it is certainly true that funds whose value goes up and down more dramatically than other investments, or the stock market as a whole, are more likely to leave you sitting on a loss at some point during the time you own them. If you have to realise the value of your investments at that point, or think that you might find yourself in that position at some point during the succeeding five years, then your risk of losing money is indeed higher than average.
But if you aren't in that position, the risk of loss is in practice considerably reduced, and may be non-existent. It is true that a Buffett, a Templeton or a Bolton is a rare beast, the very cream of a much less distinguished professional peer group. But the general point about volatility remains valid even for less exceptional talents. All the greatest investors have periods when their short-term performance looks pretty poor when measured against that of the market.
Shares in Buffett's company Berkshire Hathaway, to give just one example, fell by 50 per cent in 1973-74; by 33 per cent after the stock-market crash in 1987; by 40 per cent after the Gulf War in 1991; and by 50 per cent again at the height of the internet bubble.
Volatility is therefore an essential part of the price you have to pay for getting the best returns. But if you are a committed investor, ready to tie up your money for five years, the real risk you face is not that you will end up losing money, but that you will be bounced out of holding what is a spectacularly good investment by losing your nerve at some point along the way. Modern technology does not help the modern investor much in this respect, by enabling us all to look at a screen and see, day by day, or even minute by minute should we so wish, what the current market price of what we own happens to be.
As markets are prone to periods of irrationality, and in any event are designed to thrive on volatility, you have to accept that there will be times when what you own is not priced the way you might wish it to be.
But to go on from there and conclude that what you own really is at risk, you have to assume that the irrationality - or, in some cases, the illiquidity - of the market will extend beyond the period over which you wish to commit your money.Reuse content