One of the main points of discussion in the IOI 102 course — an Introduction to Behavioral Biases and Structural Pitfalls to Investing — is that the definition of “risk” for an principal investor of capital is very different than the way agents’ (e.g., analysts, brokers, bankers, etc.) definitions. This mismatch means that oftentimes (always?) investors are ill-served by the agents who are notionally working on their behalf!
Most investors don’t think much about risk, or (worse yet) assume that the agents’ definitions apply to them as well. For example, poll 100 people who are fully invested in the market and you won’t find one who doesn’t feel uncomfortable when the market falls 10%. However, the same investors’ discomfort levels are almost certainly much less when their portfolios are allocated all or mostly to cash while the market rises by 10%. Arguably, the latter case is more serious because the “loss” (in the form of an opportunity cost) is realized, whereas in the former case, the loss need not be.
In the IOI 102 classes, we talk about different flavors of risk — valuation risk, market risk, solvency risk, and liquidity risk — and try to assess the relative severity of each in different cases. It’s a great, eye-opening exercises and helps participants assess risk in a new light.
Imagine my surprise when I found a MarketWatch article that touched on some of these same points. The author’s initial advice is worth quoting here:
To find some direction in this rudderless market, ask yourself three questions:
1) What scares me?
2) What can I actually do about it?
3) Would that solution eliminate my fears or just shift my worries from what scares me now to what is likely to scare me next?
The idea here is to get a better understanding of risk, because your ability to withstand risk — or to balance it out — will go a long way to determining what, if anything, you do to allay your fears now.
The first month of 2016 has seen some volatility in index prices. Does this price volatility represent real risk, or is it perhaps a golden opportunity? Without an understanding of what risk really means, it’s difficult to answer this question.
To understand risk better, contact us!