Investment Risk

The chances and the consequences

It’s important we understand the risks we take in life. We need to understand the chances of something bad happening, but we also need to understand the consequences of something bad happening.

Many investment providers stress the large potential returns but almost fail to mention the associated investment risk. It’s an old sales technique. Maximise the benefits but minimise the costs. Their salesmen act like wizards who try to avoid mentioning you know who, “he who must not be named”. We take the opposite view. We believe that only by talking openly about Lord Voldemort can he, like investment risk, be understood and our inner fears controlled.

The chances of meeting Lord Voldemort are extremely low, but the consequences would be almost certain death. You have the same chance of meeting Ron Weasley, but the consequence would probably mean we would still see you again later.

I saw Lord Voldemort once at JFK airport. Actually it was the actor Ralph Fiennes that was in the immigration queue next to me and he was full of a cold. I still didn’t try to engage him in conversation though, thought it might be too risky. True story.

Is it Risk or merely Uncertainty of Outcome?

Investment risk sounds frightening and altogether final. Risk implies that if you don’t win then you must lose. Lose Totally. Completely wiped-out. But we know that most risks we take in life are not all or nothing. They really only involve a bunch of uncertain outcomes. You will achieve something, it will be just one of a range of possibilities. Here’s an example.

The light switch

When I was young the living room had the “big light” in the centre of the ceiling. A nod here must go to Peter Kay’s observations. The choice was simple, it was switched on or off. Living rooms today have down lighters, up lighters, floor lamps, wall lamps, table lamps…… Instead of one “big light” your lighting today can be adjusted depending on your requirement and mood. Forget the all on or all off choice of the 60’s. We can have a range of lighting outcomes. A range of outcomes made wider still by utilising dimmer switches.

When we invest the result is better seen as the variable output of a dimmer switch rather than the binary output of the old on or off switch. The dimmer is controlled by the markets. We don’t know what level of lighting the markets will deliver, but it is very unlikely to be either all on or all off.

We are not gambling here

Investment Risk can be seen as nothing more than a wide variety of outcomes over time. Only some of those outcomes involve actual loss. Only one of them involves total loss. Total loss occurs when everything you own is gambled. We choose heads, but the coin lands on tails. Investment is all about diversification across many things, absolute loss would involve every market, everywhere, being reduced to zero.

We know this. We know it can’t happen. Yet that uneasy gut feeling we suffer is because we still fear losing anything, as if we have lost everything. This is simply not rational.

The possibility of meeting a character from The Harry Potter Films is extremely low. But if you do meet one and it’s the wrong character, the consequences could mean a very painful death indeed. You could lose everything. Then again meet him on his day off, where airport security have screened every passenger for wands, and death would be only one of a wide range of uncertain outcomes.

Howard Scott, the grown-up who lived.