Common Misconceptions of Investment Risk
The word risk is one of the most commonly used terms in investing. With that said, we also believe it is one of the most misunderstood. Investors today have many different ideas and predispositions as to what investment risk actually is. We’ve taken some time to discuss common misconceptions and how we think about risk from those perspectives.
1. An Asset Going Up Has Low Risk
Investors often believe that there is less risk when an asset is moving higher or in an uptrend. This is a huge misconception, because risk can increase when an asset is going up and down. Both directions are extremely important when calculating the risk level of an asset.
Risk should be evaluated during rising and falling periods. This will provide investors a better picture for the asset’s risk and allow them to not be caught off guard or become complacent in an up-trending market. It also gives the ability for an investor to take earlier action should a large spike in risk occur.
2. All Risk Should Be Treated Equally
Many investors view all types of risk through one lens and don’t understand how each can impact their portfolio. Risk comes in different shapes and sizes. For example, the loss potential of owning an individual security can be significantly greater than owning all the stocks in its sector. An investor can get the sector right, while being wrong on the stock and significantly negatively impact their portfolio.
We believe risk should be evaluated on multiple levels. Trying to predict what type of risk will be the cause of a loss is virtually impossible. It’s important to understand the varying levels of risk exposure within a portfolio and how the assets are correlated to determine the magnitude of the asset’s potential loss.
3. VIX = Risk
Investors closely monitor the VIX index and use it as a barometer for risk in their investment portfolio. This is dangerous for an investor, especially considering that the VIX is only based upon one index, the S&P 500, and is constructed using the implied volatilities of a wide range of options contracts. The largest issue is that because the VIX only provides insight relative to the S&P 500, it does not consider other asset classes and segments.
Instead of solely looking at the VIX as a proxy for risk, we believe each asset in a portfolio should be evaluated. This gives a more accurate representation for the risk of a portfolio highlighting how its assets are interacting with each other and are responding in various market environments.
4. More Risk Equals More Return
Typically, investors expect more return when they take on more risk. But historically we’ve seen instances where more risk doesn’t always equal more return. Over shorter-term periods riskier assets can result in higher returns as compared to a lower risk portfolio, which can be misleading. These higher returns come at a cost. The severity of potential losses can more than offset the higher returns.
We believe investors should avoid the temptation to focus on a particular, concentrated asset that may have the potential for a high return. Instead, they should look at how a diverse group of assets can work together to meet investment objectives. A diversified portfolio with multiple asset classes (stocks, bonds, and real assets) can outperform a portfolio that is allocated 100% to equities over the long term with lower overall risk.
Risk comes in many forms and can be analyzed from various viewpoints. Risk is also much more than just simply looking at volatility. It takes true analysis and a deep understanding of potential investment risk to be able to provide investment solutions that perform how advisors and their clients expect them to. We take great pride in our quantitative assessment of risk and strive to put it at the forefront of our asset management decisions.
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INVESTING INVOLVES RISK, INCLUDING THE POTENTIAL OF LOSS OF SOME OR ALL PRINCIPAL INVESTED. INTERESTED PARTIES ARE ENCOURAGED TO REVIEW PARITAS’ FORM ADV PART 2, AS WELL AS PERTINENT PROSPECTUS/PRODUCT DESCRIPTIONS TO CONSIDER SUCH RISK PRIOR TO INVESTING. THERE IS NO GUARANTEE THAT A DIVERSIFIED PORTFOLIO WILL ENHANCE OVERALL RETURNS OR OUTPERFORM A NON-DIVERSIFIED PORTFOLIO. DIVERSIFICATION DOES NOT PROTECT AGAINST MARKET RISK. STOCK INVESTING INVOLVES RISK INCLUDING LOSS OF PRINCIPAL. PAST PERFORMANCE IS NO GUARANTEE OR PROMISE OF FUTURE SUCCESS.
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AN INVESTMENT IN BONDS CARRIES RISK. IF INTEREST RATES RISE, BOND PRICES USUALLY DECLINE. THE LONGER A BOND’S MATURITY, THE GREATER THE IMPACT A CHANGE IN INTEREST RATES CAN HAVE ON ITS PRICE. SELLING A BOND BEFORE IT REACHES ITS MATURITY MAY RESULT IN A LOSS UPON ITS SALE. BONDS ALSO CARRY THE RISK OF DEFAULT, WHICH IS THE RISK THAT THE ISSUER IS UNABLE TO MAKE FURTHER INCOME AND PRINCIPAL PAYMENTS. OTHER RISKS, INCLUDING INFLATION RISK, CALL RISK, AND PRE-PAYMENT RISK, ALSO APPLY. HIGH YIELD SECURITIES (ALSO REFERRED TO AS “JUNK BONDS”) INHERENTLY HAVE A HIGHER DEGREE OF MARKET RISK, DEFAULT RISK, AND CREDIT RISK.
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