This article originally published in The Northern Daily Leader on 12 October 2013.
One of the most basic, yet little understood notions in investing, is that of risk versus reward. In fact, the concept of risk versus reward forms part of nearly everything we do on a daily basis. When you decide to cross the road away from the pedestrian crossing or traffic lights you’re making a risk versus reward judgement. The reward is saving the 60 seconds it might take to walk to the pedestrian crossing; the risk is that you come off second best in a collision with 1,500 kilograms of steel and rubber moving at high speed. Sometimes the risks and the rewards are obvious, which makes the decision that much easier, but sometimes they’re not. We tend to be far more proficient at assessing the reward rather than the risk. We know the pleasure that we might derive from that extra glass of wine while out for dinner, but fail to correctly consider the risk that there may be an RBT on the way home. We’re even worse at considering those risks which have long term consequences. Smoking, drinking moonshine and eating lard are all activities which have long term implications, but are unlikely to kill you in the short term. Given that the payoff (or payback) occurs so far into the future, we’re happy to indulge now, with little thought of the future consequences.
As we’re better at measuring the reward, rather than the risk, it’s worth making an effort to understand the risks before making a decision, be it to cross the road or invest in BHP. A useful tool we use to assess investment risk is known as Value at Risk, or VaR. VaR is a relatively simple measure that can be used to measure the amount of financial loss that can be suffered by a portfolio of assets for a given probability. For example, an annual 10% VaR of $100,000 implies that there is a 10% chance of your portfolio falling by $100,000 over a twelve month period. VaR can be calculated for any time period and for any probability, which should allow you to correctly assess the level of risk accompanying your current or proposed suite of investments. The problem which can arise is where we let VaR over-ride our common sense. Being able to distil the entire investment risk associated with a portfolio of assets to a single figure is a neat trick, but it doesn’t absolve you further research or appropriate monitoring of your investments. Extensive number-crunching and complex financial models are useful tools to managing your investments, but don’t let the ‘magic’ obscure the truth. If it’s too good to be true, it usually is.