Investment risk, and managing it well, is critical to investing. Knowing your comfort level with potential losses, temporary or otherwise, and building a diversified portfolio based on your tolerance for risk is a useful investing principle.
Learn more about Schwab’s Investing Principles at schwab.com/investing-principles.
Each investor's definition and perception of risk will vary and be very personal. One person's sense of risk may be driven by market events. Another’s by lifetime experiences or memories. A third may have different views on risk based on their time horizon.
In this article, I introduce three categories of investment risk: volatility, benchmarks, and goals. I offer perspectives on each and share thoughts on why we feel one of these is the most impactful for many investors.
What is investment risk?
In the book, Against the Gods, economic historian Peter L. Bernstein provides an engaging exploration of risk in layperson's terms, suggesting that risk, and managing it, is at least partly about defining what may happen in the future and choosing among alternatives for a vast range of decisions, from allocating wealth to wearing a seatbelt.
I'll start in a simpler place. We probably think about investment risk as the risk of potential financial loss from decisions that may affect our portfolio. Volatility in the value of a portfolio is a place to start.
The word "risk" comes from the early Italian, risicare, which means "to dare." In this sense, risk is a choice rather than a fate.
- Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk
Volatility
Volatility, broadly stated, is a change in price, up or down, over short or long periods of time of an investment, investments, or a portfolio. It's traditionally measured or projected hourly, daily, weekly, monthly, annually, or longer over whatever time you choose. Simply stated, volatility is the relative ups and downs of price.
Here are three related measures:
- Standard deviation. This is a statistical measure, widely showing how the price or value of an investment rose or fell from its mean over a selected period. It's the most common measure of risk used today, but I'd argue it’s incomplete. Why? One reason is because many investors don't worry about "upside" volatility, but an investment that has sudden, sharp jumps upward in price is a volatile investment.
- Downside risk. This is the measure of potential, or historical, losses. We know from the field of behavioral finance that investors generally feel more pain from losses than pleasure from gains.
- Permanent loss. Volatility in the short term hardly matters, if the general direction, on average, of investments is upward. But what about permanent loss, either through an untimely sale of an investment or a permanent drop in price, even to $0?
Volatility, up and down, happens. It's part of investing, for the most part, at least in stocks and investments outside of cash or bonds. It's how you react to it that's important. Do you have the tolerance, and framing, to manage volatility when it matters?
How investors react to volatility is inherently emotional, and it often changes. How we feel and react one day may be very different than another day, if market performance changes. It isn’t math. It's emotion. And it requires self-reflection, which at times can be difficult.
The 2007-09 Financial Crisis
Did an investor in 2007-2009 really have their portfolio–and retirement–derailed by the sharp drop in markets during that period? Perhaps. But a more accurate answer likely depends on two factors: Did they have a diversified portfolio that fit their time horizon? And did they sell?
A hypothetical diversified portfolio invested 60% in stocks, 35% in investment-grade bonds, and 5% in cash investments experienced about a 37% drop in price in 2007-2009, from peak to bottom. The value of that portfolio, assuming no changes, would have recovered to its prior high in roughly three years.
Have you planned–and invested–based on your time horizon? This is one way to think about, and manage, risk.
Benchmarks
Generally, benchmarks are risk measured in comparison to something else. This can be a rough measure of the stock market as a whole (the S&P 500®, for example), a single stock you pick with a return you imagine is a reasonable target, your perception of how you think the market is doing, or (at worst, because it’s not even a true benchmark) a feeling about how your "neighbor" or another "smart investor" is doing. When chosen well, benchmarks can be helpful. If chosen poorly, or if vaguely defined, they can be harmful.
Here are some common benchmarks:
- S&P 500. This is an index, or a general measure, of a basket of the 500 largest stocks in the U.S. market. It's a widely used benchmark against which many investors, commentators, and managers, per its definition, track the performance of 500 of the largest U.S. companies. It's helpful, but less so if you have a truly diversified portfolio that includes bonds, cash, international investments, or individual securities rather than a portfolio 100% invested in U.S. large-cap stocks.
- Blended benchmark. This is a benchmark created using an allocation to other benchmarks based on a target, or personalized mix of stocks, bonds, cash, and other investments. Using an appropriate blended benchmark (ideally based on a plan or working with a planner or advisor based on your tolerance for risk, desired return, and goals) tends to be far better than using a single area of the market or a single benchmark.
- An expert on television (or your neighbors). This isn't a benchmark. It's imagined. It can be what you think your neighbor or someone you saw on TV believes about the markets or investing (often without good evidence).
Benchmarks can be emotional also, depending on which ones you choose. There's a saying I heard once from an advisor: "If you have a diversified portfolio, there may be something in it each quarter you don’t like." In every quarterly statement, there may always be a laggard. But the combination of investments is called a "portfolio" for a reason. Different pieces play different roles. Some chip in, for different purposes, when others don't.
Each asset class has a primary role in the portfolio
Source: Schwab Center for Financial Research. For illustrative purposes only.
For more information, see the Schwab Center for Financial Research Guide to Asset Classes.
Goals
While investment risk can be measured by volatility or benchmarks, we suggest it also can be measured by the risk of not achieving goals, such as retirement, the ability to pay for health care expenses, or growing assets so you can leave a legacy or buy that dream vacation home. A goal can be defined as how much money will you need, for what future expenses, when.
What is the importance of each of these goals to you, personally? How much risk are you taking, or willing to take, to achieve each goal? And are you on track to achieve them? This, we believe, is an evolved, personal measure of risk that adds to the usefulness of volatility and benchmarks.
In a holistic, wealth management framework, risk can be addressed with a question: "Am I on track to reach, and fund, my goals? Yes, or no?" This gets at the No. 1 challenge in wealth management, which is understanding what it is that an individual wants their portfolio to do. What are you trying to achieve? A natural response might be, "Make money. Pick the best investments. Beat the markets." This is natural, normal, and almost impossible. We all want to be, and often feel we are, "above average." The real task in holistic wealth management is to manage resources to achieve a goal with the lowest required, and appropriate, level of risk of hurting your finances as possible.
Here are a few ways to measure the risk of not achieving your goals:
- Probability of success. This is a metric commonly used in financial planning tools. It's not a one-time calculation. Rather, it rises and falls based on a variety of factors, including contributions or withdrawals from your portfolio and market performance. It’s an evolved measure of risk. Schwab consultants and advisors help create and then use probability of success metrics with investors at Schwab.
- Needs, wants, and wishes. Different goals may have different priorities. Financial plans can show the probability of success for needs, wants, and wishes. Investors with multiple goals can look at the risk–or probability–of meeting each goal, based on a plan that looks at performance of investments toward a target (the goal) over time.
Example of Needs, Wants, and Wishes
Source: The illustration was created using Schwab Plan, a goals-based financial planning software program. © MoneyGuide, Inc. Reproduced with permission. All rights reserved. For illustrative purposes only.
In the illustration, the needs, wants, and wishes represent personalized goals chosen by a hypothetical investor. Each goal includes projections of anticipated costs, money needed to fund the goal, timing, and other factors. The colors represent confidence zones that the goals will be achieved. In this example, the investor is aiming to stay on track to fund goals between 75% to 90% of their projected costs. This would keep the investor in the green confidence zone.
The purple zone is a projected confidence zone of funding goals below 75%, absent making any changes such as reducing spending or working longer if the goal is retirement, for example. The blue zone is a projected probability of funding goals over 90%, which is above the targeted confidence zone of 75% to 90%, and nonetheless may be appropriate for some goals, such as funding basic living expenses in retirement.
With a goal-based planning approach like this, the intent is not to achieve a 100% "score." Rather, the goal is to balance how much you save and invest to achieve goals, and the investment risk taken in your portfolio, with a confidence level of achieving your goals that feels comfortable to you. For some investors, it may be reasonable to have certain wishes, such as leaving a legacy, fall below 50%. It's a wish after all, not a necessity.
The ability to use investments to fund future or current goals is likely the most relevant investment risk for most of us. This requires self-reflection, prioritization, proper framing, and a plan. Then, measuring and testing risk involves running scenarios against those goals. Under various scenarios, including up or down markets, would the portfolio work? Would it still achieve, and fund, those goals? Without this knowledge, investors walk through an emotional minefield, almost in the dark, reacting based on their framing rather than with a disciplined assessment of risk and self-control.
Bottom line
There are different measures of risk. All can be helpful or important. For most investors, if you haven't already, consider adding to the risk toolkit–name and quantify goals, and then project the risk of not achieving them. By doing this, it may be easier to ignore distractions and focus less on markets and more on what you want your money to do for you.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Investing involves risk, including loss of principal.
The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.
IMPORTANT: The projections or other information generated by SCFR regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results.
Diversification and asset allocation strategies do not ensure a profit and cannot protect against losses in a declining market.
Past performance is no guarantee of future results, and the opinions presented cannot be viewed as an indicator of future performance.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors.
Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.
Small cap investments are subject to greater volatility than those in other asset categories.
International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes, and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.
Risks of REITs are similar to those associated with direct ownership of real estate, such as changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Investments in securities of MLPs involve risks that differ from an investment in common stock. MLPs are controlled by their general partners, which generally have conflicts of interest and limited fiduciary duties to the MLP, which may permit the general partner to favor its own interests over the MLPs.
Treasury Inflation Protected Securities (TIPS) are inflation linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the U.S. Government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.
Bank loans typically have below investment-grade credit ratings and may be subject to more credit risk, including the risk of nonpayment of principal or interest. Most bank loans have floating coupon rates that are tied to short-term reference rates like the Secured Overnight Financing Rate (SOFR), so substantial increases in interest rates may make it more difficult for issuers to service their debt and cause an increase in loan defaults. A rise in short-term references rates typically result in higher income payments for investors, however. Bank loans are typically secured by collateral posted by the issuer, or guarantees of its affiliates, the value of which may decline and be insufficient to cover repayment of the loan. Many loans are relatively illiquid or are subject to restrictions on resales, have delayed settlement periods, and may be difficult to value. Bank loans are also subject to maturity extension risk and prepayment risk.
Preferred stocks (1) generally have lower credit ratings than the firm's individual bonds, (2) generally have a lower claim to assets than the firm’s individual bonds, (3) often have higher yields than the firm’s individual bonds due to these risk characteristics, (4) are often callable, meaning the issuing company may redeem the stock at a certain price after a certain date.
Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third-parties and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
Commodity related products carry a high level of risk and are not suitable for all investors. Commodity related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions.
Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
Supporting documentation for any claims or statistical information is available upon request.
The Schwab Center for Financial Research (SCFR) is a division of Charles Schwab & Co., Inc.
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