Many financial products providers will make would-be investors go through a client suitability assessment (CSA) to see if such investors are truly compatible with the investment that they are thinking of getting into. A CSA attempts to measure a person’s propensity to take on the risks in investing.
But what is really risk and can it be measured?
The plain and simple definition of risk is the potential for losing part or all of your invested principal and expected income. Still, can risk be quantified? To answer this, let’s make an analogy.
A car is stable when travelling down the road because of its shock absorbers. And while sudden stops or abrupt turns may change the height of the car vis-à-vis the road, the latter would not be too far off from the cruising level.
But if you take out even just the rear shock absorbers and make a sudden stop, that car would bounce up and down uncontrollably, making the height of the car vis-a-vis the road in such occasions much higher than usual. Most would surely not want to be riding in a car without rear shock absorbers because apart from the uncontrollable bounce, that car may just turn turtle and end up costing lives.
We can say that an investment’s historical average annual compounded return (as discussed in a previous blog) is the same as the average cruising height of car without rear shock absorbers vs. the road. The difference between an investment’s individual historical returns and its average annual compounded returns is then equivalent to the height of each bounce of our car vs. road during sudden stops. This difference (or height of the bounce) is what is used to measure risk.
At the risk of a nosebleed, the standard deviation of historical returns on an investment vs. its average annual compounded return is that investment’s risk. Similarly, the amount of bounce of our shock absorber-less car vs. its usual height vis-a-vis the road is that car’s level of risk.
Now here is the iron tablet to help recuperate from that nosebleed. You do not have to compute risk yourself. Many free investment data service providers (e.g. Bloomberg, Reuters) as well as product providers themselves supply the computations for historical risk (standard deviation) and returns (annual compounded average) of particular investments. Some would even compute the risk of an investment (like a stock) vs. an index (like the Philippine composite index).
Suffice it to say that the higher the level of return, the higher the level of risk. And the higher the level of risk, the greater is the chance of you losing part or all of your invested principal and expected income.
So are investments that can potentially pay higher returns to be shunned altogether? Not necessarily. Remember our car example? The only way to minimize the bounce is through shock absorbers. In investing, the practice of diversification is equivalent to installing shock absorbers in your investment portfolio.
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