Even the Romans knew a thing or two about risk because as the Latin adage goes, fortune favors the bold. But life was arguably a lot simpler back then. It’s a lot harder to calculate risk and reward today, specifically when it comes to investing.
The historical way to view risk has tended to side toward market risk, looking at the volatility of assets in consideration of an uncertain market environment. But in the modern world of investments, market risk is only one element of all the risks that currently exist. Just over the past few years, risk has evolved past some previously held preconceptions.
Much of that has been driven by quantitative easing (QE), fiscal attempts by global governments to help stabilize their economies. It began in the U.S. and continued to trend across international markets, with Europe and Japan implementing their own QE programs. Under QE, central banks pump significant volumes of capital into their economies as a way to boost growth.
What exactly is the significance of this when it comes to risk? For starters, the side effect of these QE initiatives is that they fundamentally alter the valuations of various assets. Second, many investors and asset managers are still working to fully understand the implications of QE. Mix these two and you are left with a market that may be feeling nervous about a new risk they have to adapt to – on top of all the other risks there are to grasp.
How does one even first begin to understand risk? There are many facets to risk, and not all risk is created equal. In short, risk is defined as the possibility of losing something of value. But the value that something holds, and the potential associated loss, can vary dramatically depending on the individual. What is risky to one may not necessarily be risky to another.
The real challenge with risk is assessing it, especially when it comes to constructing an investment portfolio. If defining risk is how to get to understanding risk, then assessing it is how to get to that definition.
The real challenge with risk is assessing it
Risk is a multi-dimensional concept, so when investors are sorting among the various risks to assess which are more or less important to them, they can use various tools. And they can look at risk from multiple perspectives to give themselves a higher level of insight into how one category of risk can affect multiple asset classes or how one asset class can be impacted differently by varying risks.
As an example, imagine investors want to invest in foreign securities. Is currency risk more important than market risk? Is market risk more important than political risk? And what about specific geographies – is China more or less risky than other economies?
There is no magic formula to measuring or assessing risk. So sometimes it can be more beneficial to go back to basics. When investing in equities, for example, risk can take the form of buying a bad company at an unfavorable valuation. This is a risk of investing in companies without strong fundamentals, which can often occur if investors fail to step back and see the long-term, big picture.
Risk is complex because there is no straightforward answer. And as much as it is quantitative, it can be subjective with its varying definitions from investor to investor. So investors may be left asking themselves how to diversify accordingly and maximize rewards, making sure that the risk they are taking is in fact, “bold”.
Whatever the case, one thing is true: there is no reward without risk, and the Romans knew it well.