When we measure risk with an investment, it is always a practical matter, not just theoretical. This point is not particularly well understood among investors, who tend to measure risk by way of drawdowns of their mark to market value, instead of focusing on what matters, the potential for real losses that may occur.
Therefore, we see people sweating the value of their investments and portfolios based upon the last trades with them, even though they do not plan on liquidating them for a long time. While these price movements may speak to the actual risk involved when they sell their investments, for instance limiting the prospects of actually selling them later at a profit, we cannot and should not trouble ourselves with short term price fluctuations when we are not trading in that time frame.
The only thing to focus on is what the risk may be when we do sell. This is where gains and losses are realized, and the only time that they are.
It is not even that those with longer time frames can take on more risk, as this is another misunderstanding, because risk is risk, and if you are risking too much that’s something you want to try to manage better. Not understanding this properly can actually have investors taking on too much risk, meaning that their risk when they do sell is too high because they are told that if they are investing for 20 years for instance, where things go doesn’t matter.
What can happen with this is that their investments may behave in such a way that increases their risk at selling, and this should be more accounted for, but they just look the other way because they are permitted to take on more risk.
If anything, long term investments are riskier and have less tolerance for risk, but that can only be understood if we see the risk as being what happens in the end, and not necessarily what’s going on right now.
So, it’s not that long term time frames necessarily are less risky or can afford to be, it’s more that the perspective is longer so we need to view our investments that way and ensure that we actually cast our gaze on the long term, because that’s really the only thing that matters here.
It’s Not So Easy to Predict the Future
Longer term investments are much more hard to predict than shorter term ones, both in terms of measuring performance and risk. The longer the time frame, the more things will happen to potentially change things, and we can’t just rely on past performance here to tell the story, like so many people do.
Once we get our heads straight on what really matters, and should we choose the longer-term view, which isn’t necessarily the only one or even the best one, we then need to look at how changing conditions will affect our investments in our chosen time frame.
This means that, as time goes on and we move closer and closer to the desired time frame we have chosen, we look at happenings along the way not in terms of what would be the result if we sold our investments now, as most people do, but how these movements, price movements and changes in outlook, may affect us in our own time frame.
This is not an easy task by any means and in fact is very difficult to do well even by those whose expertise lies in predicting such things, and anyone who is familiar at all with market predictions know that often times the experts end up being wrong and sometimes dead wrong.
It’s easier of course to just ignore all of these forecasts and prognostications and just hold fast no matter what may happen, but this is not in any sense an intelligent way to manage investments. If you continually see no evil, that may be better than trying to see it and messing up, which happens quite a bit, but we should not set our ambitions so low that we are just leaving everything completely up to fate either.
Practically speaking though, making predictions far into the future is simply beyond our abilities, and we are better served managing things in the time frames that we can manage, basing our decisions on information that is considerably more reliable and knowable.
The investment industry loves the blind man approach to this though because investors doing absolutely nothing and making no decisions at all that are based upon market information is the ideal for them, but it may not be the ideal for us, and it is us that matter here from our perspective.
The typical approach is to look at our time horizons, strongly encourage us to expand them to retirement at least, and then tell us to just do nothing until that day comes, because we can take on a lot more risk because we’re investing for so long.
If we are told that we can be riskier with our investments if we invest for longer, that’s going to seem to be pretty tempting, but with our retirement on the line, we need to be more risk averse when it comes to where we will end up. We will work all our lives to prepare for this, a time where we cannot or do not wish to work anymore, and our well being will depend on how well our investments perform, so we owe it to ourselves to do what we can to best ensure that these goals are reached.
If we are just investing and hoping, like most people do, and we could do more to help ourselves, we’re putting too much faith in chance, and this chance does indeed mean risk, because we may not be as lucky as we hope we will be, and be handed failure to various degrees.
Managing Both Risk and Reward Over the Long Term
How much time one has to retirement when one is saving for retirement does matter, and if one has a few years left to go, the strategy may be different than if one has several decades, although this is not necessarily the case.
This all depends on one’s investment strategy, and the focus of one’s strategy and the overall time frame of one’s investment goals are not necessarily one in the same.
Someone can plan on investing for 40 years for instance until retirement, and still select a market perspective that is much shorter than this. We should never just automatically align the two, and if we’re going to want to stay in our positions for the 40 years, we need a very good reason to do this, and because that’s when we plan on retire is certainly not one of them.
The more thought we put into our investing, and the better we manage them in turn, both performance and risk management will tend to be enhanced.
The completely passive approach does not manage either, not well, not at all in fact, because all is left to chance essentially, how much money we may make or lose. We cannot know with any certainty that the past will just be repeated, we can only hope it will.
We are taught to think that, because our retirement savings are so important, the passive approach is the right one, because otherwise we will be behaving in a way that will increase and perhaps even greatly increase our risk.
While bad management can clearly do this, that’s certainly not our goal, and to the degree that we do look to actively manage our portfolios, it is critical that we do so well and not poorly. Just the fact that some people may mess this up though should never be seen as a reason not to strive for this though.
The best approach, if we can manage it, is to invest with a view of not only increasing our performance, but even more importantly, to lower our risk as well. Risk and reward are often understood as opposing forces, where if we strive for better returns we need to take on more risk, and if we look to lower risk we need to be satisfied with lower returns.
This may be true to an extent with some particular investments, for instance nothing beats the potential return of investing in cybercurrencies but their risk is also off the scale, but this isn’t really true with portfolio management, or at least it isn’t if portfolios are managed correctly.
Hedge funds for instance tend to both be less risky and perform better than the market, the hedge funds that are managed well that is, although poorly managed ones may indeed take on too much risk. One of the goals of a good hedge fund is to manage risk, by limiting losses more than mutual funds do, as well as hedging them better.
Where We End Up is What Matters
Just because we may not be looking to spend the money earned or invested until we retire, this doesn’t mean that we cannot or should not seek to manage this pool of money in a way that seeks to improve market returns as well as reduce the risk of our ultimately falling short of our investment and retirement goals.
If our time frame is longer, this just means that there is more room to play with so to speak, as opposed to our having a goal which is just a couple of years and we either succeed or do not. Should we suffer setbacks, and there is a long time to make up for it, this is to our advantage, similar to how bear markets are seen as less significant in long term investment horizons.
Where we end up, how much we have in retirement, how well off we will be, does depend a lot on how much money we allocate for this, but it also is determined by how well we manage this money.
We should not be put out by the importance of achieving our retirement goals and allow this to become afraid to manage our retirement portfolios more actively. There is something to fear here, but it’s not the time frame, it’s the risk of our mismanaging our investments, and this fear does need to be taken seriously.
However, if we reach a point where we feel that we are up for the task and can seek to manage both the performance of our retirement investments and the risk involved with them with sufficient skill, the importance in our lives of these investments should have us more and not less willing to do so.
This can end up making a huge difference in where we end up, as well as our likelihood of being much happier in retirement, and there is too much at stake here for us to necessarily just go with the approach of crossing our fingers.
Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.