The true nature of investment risk

David MoonBlog

by David Moon

One of the many misleading principles espoused by much of the investment industry is that historic volatility is an appropriate measure of risk. That is, the more the price of an investment has bounced around in the past, the more risky it is. And in order to earn high returns you must accept more systematic risk.

For long-term investors, the opposite is true. Volatility creates opportunities to both reduce risk and increase returns.

The biggest attraction of using volatility as a definition of risk is that it can be measured with precision—a false accuracy that creates an impressive illusion of usefulness. A downside of this definition is that it is a combination of consultant-speak and academic gobbledygook.

Common sense suggests that investment risk is a measure of the probability of losing money. A major downside to this definition is that, unlike volatility, the likelihood of losing money can’t be measured and calculated to two decimal places.

The simple genius of the “losing money” definition of risk, however, is that is makes sense.

Go to an equipment auction some time and watch the deceivingly wealthy men in worn blue jeans and pickup trucks. Those old-timers know that the risk of buying a used Caterpillar D6 depends on what that bulldozer is worth compared to the price at which they can buy it. No one at an auction ever asked for the standard deviation or beta on that dump truck. These equipment investors understand that when it’s raining and only a handful of people show up for an absolute auction, demand declines, prices decline, risk declines and the likelihood of making money increases.

Lower risk, higher returns. The concept is no different among highly successful stock investors.

I have two friends who have each been recognized as Morningstar’s mutual fund manager of the year. They have outstanding, long-term track records—and they each chuckle at the idea that risk can be measured with statistical precision.

In practice, there are different types of risk, many of which can be avoided with a little common sense. If you need your money in the next three years, don’t put it in stocks, no matter how diversified across a collection of mutual funds.

If you’re saving for retirement or some other goal in the hard-to-fathom distant future, your biggest risk is that your money won’t earn a reasonable rate in excess of inflation. Volatility is irrelevant to you, or should be. The diversification of owning ten mutual funds offers very expensive and deceiving peace of mind. Indiscriminate, hyper-diversification, however, is the equivalent of removing your shoes at the airport. It is a theatrical proxy for reducing risk—and not a very effective one, at that.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN)