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Reframing risk for investment success

By Jared Kadziolka, CFA 16 April 2024 4 min read

Much like the term ‘debt,’ the concept of ‘risk’ primarily has a negative connotation. From an investing point of view, the notion of risk can stoke concern over potential negative returns, and ultimately a sense of caution and apprehension.

But, just as there is ‘good debt,’ risk actually has an important role to play in a healthy investment portfolio. It’s important for investors to recognize that risk is not inherently a negative feature of investing that should be avoided or minimized—rather it’s an essential attribute that provides the opportunity for meaningful growth of a portfolio. 

In this article, we'll explore a broad and commonly used definition of risk in the markets while also introducing an alternative interpretation that can provide investors a more well-rounded and personalized perspective. By broadening and reframing one’s understanding of risk, investors can more confidently navigate the inherent uncertainty of the investment landscape, putting them in a better position for long-term financial success.


What is risk?

As it relates to investing, risk doesn’t mean an increased likelihood of poor outcomes. Rather, it simply means a lack of guaranteed outcomes. An investment’s volatility or the variability of its returns is what is commonly referred to as risk. Standard deviation is a statistical measure that provides investors with insight around an investment's volatility. Standard deviation reveals how much an investment’s historical returns have differed from its average return over a specified period. If the standard deviation is high, it means the returns have varied widely from the average, indicating greater volatility. On the other hand, a low standard deviation suggests greater consistency in returns. Essentially, standard deviation provides insight into the level of risk associated with an investment—the higher the standard deviation, the higher the risk, and vice versa.

Comparison of low- and high-volatility portfolios over 10 years

Source: ATB Wealth

The above chart illustrates annual returns for two hypothetical portfolios over a 10-year period. Portfolio A’s returns had smaller fluctuations each year (displayed less volatility) while Portfolio B’s returns had greater fluctuations or volatility. The differing levels of volatility of each portfolio are reflected in their standard deviations, with Portfolio B having a greater standard deviation than Portfolio A.

It’s important to note that higher volatility is not necessarily a bad thing as it is inherently tied to the possibility of greater returns—particularly over the long term. Over the short term, however, investments with greater volatility tend to provide greater likelihood of both increased frequency and magnitude of declines. This is highlighted in the above chart with Portfolio B having a higher standard deviation as well as a higher average return. 

Historical volatility metrics such as standard deviation provide valuable insights into an investment's past performance. While understanding the magnitude of fluctuations can help inform reasonable expectations for the future, focusing solely on volatility may obscure the broader context of why a degree of risk is often necessary in achieving one’s investment goals. While investors may strive to minimize volatility and avoid short-term losses, this approach may not always align with long-term financial aspirations.


An alternative perspective

Since investors will have specific financial goals in mind, the main objective of investing and assuming volatility is to achieve those goals. After all, most individuals would require this motivation in order to be willing to accept the natural discomfort associated with uncertain and potentially negative outcomes in the first place. As such, the potential shortfall in meeting one’s financial goals—a concept known as shortfall risk—should be a key consideration when investing.

Shortfall risk is a more personalized risk concept that can help round out the traditional volatility-related definition. Rather than focusing solely on the potential for negative returns in a given year, investors should also consider whether their investment portfolio has a reasonable chance to generate sufficient returns to fund their goals. This shift in perspective underscores the trade-off between uncertainty in the short term and the potential for meaningful investment growth over the longer term.

Consider a scenario where an investor aims to maintain a desired lifestyle through retirement, and it requires their portfolio to generate an average annualized return of five per cent. While a portfolio of stocks and bonds will carry volatility and occasionally deliver negative returns, it offers the potential to meet the investor’s long-term objectives. In contrast, a more conservative investment with a stable but lower expected return of three per cent would be considered less risky by conventional standards. However, its long-term expected return falls short of meeting the investor’s required rate of return and poses a greater risk in terms of achieving long-term objectives. When viewed with the perspective of shortfall risk, the more volatile or traditionally risky portfolio may actually be considered the less risky investment as it pertains to the investor’s goals.


Final thoughts

Reframing risk can help investors consider a more personalized and holistic view of their investment journey—one that transcends short-term fluctuations and also emphasizes their investment goals. By getting comfortable with risk, and its relationship to return and investment goals, investors can navigate the path to financial success with greater confidence and clarity.

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