A primer on what risk is, and why it's important
Risk is perhaps the most important concept that someone can use to determine where they end up in life, not just financially but in all other aspects of their life.
It’s therefore surprisingly to me that so many people have such a lackluster understanding of this key concept that underpins every aspect of their own personal lives.
Thanks for reading Tiago’s Newsletter! Subscribe for free to receive new posts and support my work.
What is risk?
That’s a fairly benign and straightforward definition for the things that the average person considers as risk.
To bad it’s wrong.
Well, not so much as wrong but incomplete.
At the end of the day, risk is not just negative, it can also be a positive risk, or both.
We don’t even have to go out hunting for obscure scenarios where a risk is always positive.
Anyone who has ever asked someone out on a date will have taken a risk whose results have some positive to them always. If they accept, you now got a date, if they reject, you now know they are not interested and can move on.
That said this is a financial newsletter, and so it’s natural that we focus primarily on financial terms, in which case a definition like the one we find on investopedia is a more accurate one:
Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment.
Fundamentally financial risk is risk that you lose money on your investments.
But there’s more to it than that, isn’t there?
After all there’s several types of investment risk:
Interest Rate Risk
Almost every investment, from the home you live in, to the stocks and bonds you buy has at least some of these risks.
Some have all of them!
And of course the level of risk also changes from investment to investment, for example there is usually little interest rate risk in owning a business with no debt, whereas if the same business had a lot of debt then the level of interest rate risk would go up.
Fundamentally though we can divide all financial risk into one of 2 types:
That is a risk that affects the entire market (or market segment).
This is a type of risk that you generally cannot diversify away from, or meaningfully minimize.
A clear example of systematic risk would be something like a large scale meteor similar to the one that wiped out the dinosaurs.
Generally speaking no matter what you do, or where you are, if a huge meteor hits the earth your business will be meaningfully affected.
This is risk that is generally unique to your business, and is unrelated to the rest of the market.
The cleanest example is that of a companies ability to continue as a going concern.
If a company has a lot of debt, and no way to repay it, then their business and credit risk are not in the best position.
How we look at risk
Another important thing to look at is to not just understand what risks you’re exposed to, and to what extent you’re exposed to them, but also how you’re approaching those risks.
This is a large part of where people fail to think critically, and where they make big mistakes.
Many investors, and real estate investors are particularly prone to this, are mildly aware of at least some of the risks they are taking.
They know that earthquakes are a possibility, or that tenants may chose not to pay rent, or that the government may suddenly decide an extraordinary tax is in order.
But they still invest at the same price because “it’s the market price and otherwise i won’t have the rents coming in”.
This is a terrible idea because they are taking on those risks without being compensated for taking those risks.
Many real estate investors are blindly taking on huge amounts of uncompensated risk without realizing it.
And part of the issue is the financial shibboleths which say:
The higher the risk the higher the reward.
A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return.
This is a common refrain, and there are innumerable scientific papers about this, and lots of investors saying this.
The funny thing is that it’s simply not true.
Let me be clear here.
There is no relation between risk and return.
I know, what I just said goes against everything you will have ever learned in your university finance class, and yet I’m absolutely right about that.
Don’t believe me?
Go to your nearest homeless drug addict and give him $1000 in return to a promise for him to repay you $1000 a year from now.
Do you think your expected return of $0 is compensating you for the risk that he will just take the money and run?
If your answer to that is anything other than “no, it’s not compensating me for that risk”, then you’ve now encountered the concept of Uncompensated Risk, and why the idea that risk and return are intrinsically connected is wrong.
Ultimately whatever statistical connection in the data showing a relationship between risk and return that you see only exists because investors demand to be compensated by the risk they are taking on.
If investors are taking on uncompensated risk, then such a connection does not exist!
Today we’ve learned a bit about financial risk, and the core concept that you must be the one to demand compensation for the risks you’re taking on, and if you don’t you’re doing so at your own peril and cost!
You can demand such compensation by being willing to pay a lower price, or requiring a higher return to invest.
But remember, if you take on too much uncompensated risk, whether you’re aware of it or not, then all you’re doing is transferring cash from your bank account to the bank accounts of your counter-parties while getting nothing for it!
Check your risk.
Think it through.
Demand the right price.