The Ironic Truth About Investment Risk

It is an undeniable fact that investing involves risk. The reason stocks have a higher expected return than bonds is because investing in the stock market means taking on risk. We spend so much time focusing on investment risk that we forget the ironic truth about risk which is that Avoiding risk is the greatest risk of all.

Risk can’t be eliminated

The first thing to know about risk is that there is no way to avoid risk. It can only be managed. You can avoid investment risk by refusing to invest in the stock market or other “risky” assets. In doing so, you simply trade investment risk for what I call “opportunity-cost risk”.

Opportunity-cost risk is the risk of losing out on years of compounded investment returns that you would have earned had you invested your money more aggressively. Every decision has an opportunity cost. By taking certain actions to avoid one type of risk, you simply introduce a new type of risk.

I repeat, risk cannot be avoided it can only be managed.

To manage risk, we need to know which risks to embrace, which risks to avoid, and when. The most important factor when deciding how to manage risk is our time horizon. When do you need this money? In the short term (within a few years) or the long term (within a few decades)?

Managing short term risk

If you are saving money for a short-term goal like buying a house, buying a car or building an emergency fund then it makes sense to focus on managing your investment risk. These are situations where the potential reward of investing is simply too small relative to the risk.

If you have $10,000 saved up that you want to put towards buying a house in the next year, what would be the risk-reward proposition of investing that money in the stock market?

The most likely best-case scenario would be a solid year in the market, where you make a 10% return on your investment. You just turned $10,000 into $11,000. That extra ,000 might come in handy to cover some minor renovations or to help furnish your new home.

The worst-case scenario would be a market crash in which your $10,000 investment drops to $5,000. In this scenario, you may not have enough for the down payment and miss out on buying that house altogether.

Is $1,000 worth risking the opportunity to buy a house? I don’t think so.

In the short term, our investment risk should be close to zero. The added benefit of having zero investment risk in your short-term money is that you have limited opportunity-cost risk. It’s not likely you’ll miss out on huge investment gains with a 1–2-year time horizon.

Your goal should be to eliminate investment risk with short term money.

Managing long term risk

If you are saving for a long-term financial objective such as retirement you need to embrace investment risk and manage your opportunity cost risk.

If you have a multi-decade time horizon, you should not care or even pay attention to what happens in the stock market today.

This is assuming you are investments are well diversified in something like a low-cost index fund. If you are investing in individual stocks, the performance of those stocks is something that needs to be monitored closely.

The worst-case scenario in the stock market is another financial crisis like we saw in 2008–2009. So, let’s use that as an example to demonstrate why investors with a multi-decade time horizon should not be concerned about the day to day movement of the stock market.

Let’s say you invested $10,000 in an S&P 500 index fund in October 2007, which was the peak of the market before it crashed.

• Over the next 15 months, your portfolio would have lost 53% of its value.
• By February 2009 you would have less than $4,700 left.
• Today, if you simply held onto your original investment you would have $18,700 (87% return on investment).
• If you reinvested your dividends back into buying more units of the index fund you would have $23,600 (136% return on investment).
• class=”graf graf–li”>If instead, you decided to put your $10,000 in a savings account earning 2% per year, you would have about $12,700 (27% return on investment).

In this example, even though we invested at the “worst possible time” we came out with twice as much money over 12 years by investing in the market versus “playing it safe” and keeping our money in cash.

The market rewards long-term investors 

Over a 30-year time horizon, what is the opportunity cost of keeping your money in cash compared to investing in the stock market?

Assuming;

• $10,000 was added to your savings per year.
• Your average return on investment was 7% in the stock market.
• You Received a 2% interest rate on your savings account.

After 30 years,

• You would have over $1 million if you invested in the stock market.
• You would have $414,000 if you kept your money in cash.

Furthermore,

• Your $1 million in stocks, $300,000 would be made up of your contributions and $700,000 would be made up of investment returns.
• Your $414,000 in cash, $300,000 would be made up of your contributions and $114,000 would be made up of interest.

To avoid the “risk” of investing, you would have given up $586,000.

So, I repeat, the ironic truth about risk is that avoiding risk is the greatest risk of all.

Putting it All Together

I am not advocating that you dedicate 100% of your retirement savings into the stock market. I am suggesting that you weigh investment risk based on your investing time horizon.

The longer the time horizon the less you need to worry about investment risk and the more you need to worry about opportunity cost.

The reverse is also true. As you get closer to retirement it makes sense to lower your investment risk as your time horizon is shrinking.

How do you manage risk in your portfolio? Do you consider your time horizon when choosing your investment allocation? Let me know in the comments.

About the Author

Ben Le Fort

Ben Le Fort is a personal finance writer and creator of the online publication “Making of a Millionaire.” He has been passionate about personal finance ever since graduating University with $50,000+ in debt.

In the eight years following graduation, he paid off all of the debt and built a seven-figure net worth. Ben holds a Bachelor’s degree in economics from Acadia University and a Master’s degree in Economics & Finance from The University of Guelph.

Ben lives in Waterloo, Ontario, with his wife, son, and cat named Trixie.