What is Risk?

As investors, the decisions and actions we take today influence our future returns. We are constantly assessing and predicting how the future returns are going to look like.

While it is quite easy to imagine very positive and rosy future returns, it is also important to contemplate all the various possibilities. When thinking about all possibilities, some not so good future scenarios come to mind, some really bad and horrific future outlook is also conceivable. Understanding all possibilities and the likelihood that any such possibility will actually transpire is critical to making the right decisions today.

What is Risk?

The concept of risk embodies the range of future scenarios to give us a better handle on decision making at the present time. It helps answer the following question - What decisions should I make today so that the chances of positive outcome for the future is enhanced and chances for negative and really bad outcomes are diminished?

Understanding risk and making smart decisions based on this understanding has great potential to consistently generate better returns over time. It reduces the guesswork involved in picking investment options by enabling us to compare disparate investments in a measurable way. Let us look at an example to drive home the concept of risk.

Consider that you are in the market to buy a residential rental property. You are researching the location to buy this property. Your choices are either to buy it in the suburbs of a metropolitan city or to buy it by the beach. If you buy it in the suburbs, you are likely to rent it out to a family that lives and works in that area. They will pay a steady rent throughout the year. If you buy it by the beach, you are likely to rent it to tourists who visit the beach for a few days to a few weeks every year. You will have busy summers when the demand is high and boring winters when there is hardly any one asking to rent the property. Based on the rent collection you can make year over year, it appears that the beach property is riskier than the suburban property. The rental income from the beach property is likely to vary from year to year and also over a wide dollar range based on how occupied the property was during summers.

How do you compare these two properties so you can make an informed decision to maximize the returns from your investment over a period of, say, 10 years?

Let us say you expect the beach property to be occupied only 50% of the time every year while the suburban property to be occupied almost 100% of the time every year. Let us also simplify things by assuming that the expenses to maintain the property including taxes are the same at both places. If you get $100 per month in rent at the suburban property, you would need to get $200 per month on an average at the beach property to match the returns from the suburban property.

There is one important thing to consider in addition. Since the beach property on an average is occupied 50% of the time, but not every year, the variability of occupancy subtracts from your returns as an investor. Say, during one year the property was only occupied 20% of the time. The income that came from the property was not sufficient to payoff all your expenses that year. You will need to maintain additional funds to manage the cash flows. There is a cost to this.

A second consideration due to the variability of occupancy is that it introduces variability in your profit margins. This variability introduces a drag on your compounded gains over time unlike the steady profit margins from the suburban property.

These additional considerations means that for you to buy the beach property, either the price of the property should be lower than the suburban property or the monthly rent expected should be sufficiently higher. Another way of saying the same is that the beach property is a riskier investment compared to the suburban property.

Risk can manifest in other ways. An investment where the potential for loss of principal is higher compared to another investment can be said as riskier. A business where the chances of success are relatively lower to another investment can be said as riskier. In the biotech industry, a new drug development goes through multiple stages of development. At early stages the chances of success are very low. As the drug progresses through each stage, the chances of success improve dramatically. Thus betting on the development of one drug is extremely risky. To reduce the risk, biotech companies start out with many candidate drugs with the hope that at least a few of them make it to the final stage. This reduces the overall risk to the firm.

Understanding risk is very critical for successful investments. As you may have gathered through the examples here that the assessment of risk is very domain dependent. To be a successful investor you need to know about things very broadly as well as deeply. If you would like to assess the risk in your portfolio, give us a call or setup a time to talk to your financial advisor.