What is Investment Risk?

Depending on whom and when, we ask, we’ll get different answers.   During the Internet bubble in the early 2000s, investment risk didn’t mean losing money; it meant making less than someone else.   What many people feared was bumping into another person who was getting richer even quicker by day-trading dot-com stocks than they were.   Then, suddenly, when the Internet bubble popped in 2002, investment risk had come to mean that the stock market might keep dropping until it wiped out whatever traces of wealth they still had left.

While its meaning may seem nearly as fickle and fluctuating as the financial markets themselves, investment risk has some profound and permanent attributes.   The biggest gamblers who make the biggest gains in a bull market are almost the ones that get hurt the worst in a bear market that follows.  And once he loses big money, he then has to gamble harder just to recover, like a casino gambler who desperately doubles up after every bad bet.   Unless he is lucky, that’s a recipe for disaster.

No wonder, when people ask our firm’s professionals to sum up everything we have learned about how to get rich, we answer “Rule number one, don’t lose.  Rule number two, read rule number one.”

This graph below shows what we mean.

2-Chart-The-Cost-of-Loss

Imagine that you find a investment that you think can grow 10% per year even if the market grows 5% annually.  Unfortunately, you pay too much, and the investment loses 50% of its value in the first year.   Even though the investment generates double the market’s return, it will take you more than 16 years to overtake the market.

Losing money is an inevitable part of investing, and there’s nothing we can do to prevent it.  By refusing to pay too much for an investment, we minimize the chances that our client’s wealth will be destroyed.