Risk, can we get serious now and talk about it?

In my previous post, I shared a simple investment strategy. Personally, I prefer calling it Risk Management, the reason being an investment is all about the risk an investor willing to take to earn the desired return. The one problem I have noticed among investors, they spend most of their time talking about return and less about risk.

In this post, I will explore the Risk v Reward rule. Before that, let’s revisit a statement in my Which Comes First, Savings or Investments post; “Investment is based purely on Risk vs Reward rule. Most investors tend to concentrate on Reward (out of our control) and neglect the risk (within our control).”  

I can’t stress enough the importance of spending more time thinking about actions within our control, the investment risk in this case and less time on out of our control results, especially investment return.

Why do we only speak about the return? I can only assume; we Malaysians are too familiar and comfortable investing in zero capital investment loss instruments.

Risk v Reward:

Note: I’ll admit, the way the asset classes are grouped together are debatable based on current trends. I’ll definitely be sharing more on asset classes later on. For now, we shall ignore it and concentrate on the risk factor.

Around two years ago, my friend Vasanthan shared the above diagram explaining the Risk v Reward rule based on investment asset classes available in Malaysia. It’s a simple but very effective diagram for investors understanding of investment risk. At one glance, most would have noticed running your own business has the highest risk and reward. But here is the catch, as explained by Vasanthan, high risk means high reward which can also mean high loss. To simplify it:

High Risk = High Return = High Loss

Just because the word loss is missing from the Risk v Reward rule, we shouldn’t be ignoring it. Ask any business owner you know, especially the SME owners in Malaysia if it is easy to get a bank loan during the first few years running their business.  The answer will be no, because from the bank point of view, they are taking too much risk lending out money to business owners who have a higher chance of failing. There is a statistic on this, something along the line majority of new businesses fail within the first three years. I’ll update here if I manage to find the statistic.

Dependent v Independent:

To understand the diagram better, let’s look at the famous linear equation “y=mx + c”. The independent variable is represented by the horizontal x axis and the dependent variable is represented by the vertical y axis. Based on the Risk v Reward diagram shared above, x is Risk (independent variable) while y is Reward (dependent variable). This clearly shows Return or Reward is dependent on the Risk taken. Therefore, investors should concentrate more on the risk taken, since it is within his/her control and concentrate less on the return.

Since high risk is high loss, does that mean we should avoid high-risk investment? No, depending on the investor’s risk appetite, he/she should be concentrating on limiting their risk exposure to avoid high losses. In my next post, I’ll explain in detail the meaning of investment risk and share another important entity “time”, which is also within the investor’s control.