One of the most misunderstood aspects of investing is risk and how to manage it. Yet, of the two variables that are inherent in every investment - risk and return - risk is by far the most important. It is the only variable that has the potential of being managed and controlled to a significant degree.
While there are many different levels and types of risks, two are of crucial importance. The first, and most feared risk, is the loss of capital. When you think about it, you'll probably agree that an investor does have the ability to decide how much risk to assume before committing his capital.
There's one absolute question that must be asked. Does the contemplated investment have any meaningful probability of losing 100 percent of its value?
I would suggest that an objective and diligent examination of the risk factors will provide a clear answer for most investments most of the time. For example, what do you think is the probability of a total loss of capital invested in a global portfolio of equities through a professionally managed mutual fund?
Now, ask the same question when the same amount of money is invested in just a few individual stocks? Again, what is the probability of a total loss by being diversified across, let's say, 10 asset categories as compared to being concentrated in one category?
Not to belabor my point, but does investing in regulated and transparent vehicles have anywhere near the probability of total loss as putting the money into an unregulated, hard to understand vehicle? I don't think so.
The second risk, widely known as market risk, is the fluctuation of investment returns over time. Despite many investors' belief to the contrary, no one has any control over this risk. This is the realm of market timing, betting on great ideas, making predictions and following trading models and theories.
For all practical purposes, the market determines what return it will pay over time, and no one can influence or predict that. Please note that we are talking here about either positive or negative returns for a given time period, not loss of capital. An investor will only lose money if he sells when the investment has declined in value. Most of the time, that decision is one of exercising control.
If we want to manage these risks, we'll need to talk about one of the most persistent marketing illusions in the business. This illusion holds that there is some fixed quantity of risk tolerance, i.e. acceptance of a loss of capital, in every investor's mind.
In the 30 years that I have been in this profession, I have never met an investor who was explicitly OK with the potential loss of his/her capital, regardless of the promised return.
Yet, it's an unfortunate reality that many expose their capital to total loss because they fall prey to the Siren song of having found that one special investment with a high return that supposedly doesn't have any significant risk. Sadly, we see this pattern unfold in many different ways and not only in such blatant examples as Bernie Madoff's Ponzi scheme.