How Much Risk Should You Take? - YouTube

Risk is more than an important part  of investing. The whole concept of  

a financial market exists on the basis that  taking risk can result in financial gain. If  

you do not take risk in financial markets,  you expect very low returns. Of course,  

with risk also comes the potential for  loss. Elroy Dimson of the London School  

of Economics said “Risk means more  things can happen than will happen”.

In other words, risk means that there is a  distribution of outcomes, and you will not  

know which outcome you actually get until it  happens. As much as we like to think that we  

can understand risk, the possible distribution  of outcomes is beyond our ability to comprehend.

While we are not able to control or  predict the distribution of outcomes,  

we are able to choose the type and amount  of risk that we take with our investments.

I’m Ben Felix, Associate Portfolio  Manager at PWL Capital. In this  

episode of Common Sense Investing,  I’m going to tell you about risk.

To start this discussion, I need to introduce two  types of risk. The first type of risk is called  

idiosyncratic risk, which may also be referred  to as company specific risk, or diversifiable  

risk. Idiosyncratic risk is not directly related  to the market as a whole. Individual stocks will  

typically move to some extent with the market,  but they may also fluctuate due to their specific  

circumstances. Think about Volkswagen’s share  price plummeting after their emissions scandal.

There is no reason to expect a positive  outcome for taking on idiosyncratic risk.  

It may work out in your favour, but it may  result in substantial and unrecoverable  

losses. Idiosyncratic risk can be diversified  away. Owning all of the stocks in the market  

eliminates the specific risks of each  company. What is left is market risk.

Market risk is the risk of the market as a whole.  It cannot be diversified away. For taking on the  

risk of the market, investors do expect a positive  long-term return. When you invest in one stock,  

or one sector, you are getting exposure to  both market risk and idiosyncratic risk,  

but the idiosyncratic risk can easily dominate  the outcome. The most reliable long-term outcome  

would be expected when idiosyncratic  is diversified away. Practically,  

this simply means owning a globally  diversified portfolio of index funds,  

an idea that is not new to anyone  who has been watching my videos.

Most investors do not own a 100% equity  portfolio. Portfolios will typically consist  

of some mix between equity index funds and bond  index funds. Long-term outcomes are uncertain,  

but we know that over the past 116 years  stocks have outperformed bonds globally,  

while bonds have been less volatile.  A portfolio becomes less risky and has  

a lower expected return as the  allocation to bonds increases.

The decision about how much risk  to take is driven by the ability,  

willingness, and need to take risk.

Equity market risk has tended to  pay off over long periods of time,  

and the distribution of outcomes  also tends to narrow. For example,  

over the 877 overlapping 15 year periods from  1928 to 2015, the US market outperformed risk-free  

t-bills 96% of the time. The ability to take  risk is primarily driven by time horizon and  

human capital. We have been talking about risk  as an unpredictable distribution of outcomes.  

A more tangible definition might be the  probability of not meeting your goals.

For a young person with lots  of remaining earning capacity,  

the market underperforming t-bills hardly affects  their ability to meet their goals - in fact,  

it would be a good opportunity for them  to buy cheap stocks. On the other hand,  

a near-retiree taking substantial losses  in the years leading up to retirement would  

be devastating to their ability to meet their  spending goals. In general, it is sensible to  

take less risk for goals with short time horizons  and more risk for goals with longer time horizons.

Even with an unlimited ability to take risk,  most investors are constrained by their own  

willingness to take risk. An investor may look  at the history of market risk and decide that  

it is too volatile for their preferences.  The MSCI All Country World Index was down  

33% in Canadian dollars between March  2008 and February 2009. That’s a pretty  

big drop. In his book Antifragile, Nassim Taleb  introduced what he calls the Lucretius Problem:  

we tend to view the worst historical  outcome as the worst possible outcome,  

but that is nowhere near the truth. If a 33% drop  scares you, you would need to be comfortable with  

the potential for a far deeper decline to be  confident investing in a 100% equity portfolio.

The need to take risk brings us back to goals. If  someone wants to spend $5,000 per month adjusted  

for 2% average inflation for a 30-year retirement,  they would need about $2.5 million dollars to be  

able to afford to take no risk. They could hold  cash in savings deposits and deplete their assets  

over time without any volatility. Most people  do not accumulate enough to fund a risk-free  

retirement, so they must introduce some level  of risk to increase their expected returns..

The right amount of market risk in a portfolio  is sufficient to hopefully meet the goal for  

the assets without introducing the potential  for catastrophic failure due to large declines  

at the wrong time. There are rules of thumb out  there, like having 100 minus your age in stocks,  

but they have little basis. Truly there is no  optimal answer, but there is little debate that  

expected returns and expected volatility  are highest with a 100% equity portfolio,  

and investors will add in bonds to match their  ability, willingness, and need to take risk.

How do you handle risk in your portfolio?  Tell me about it in the comments.

Thanks for watching. My name is Ben Felix  of PWL Capital and this is Common Sense  

Investing. I’ll be talking about a lot more  common sense investing topics in this series,  

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