Market insights and analysis

By Jerry Wagner

Investors are so different. They pursue different goals. They react differently to changes in the financial marketplace. Some are aggressive. Some are conservative. Sometimes they are very concerned with risk, and other times they seem able to ignore it.

This suggests that some investors don’t really understand what risk is all about.

After almost 50 years of researching the financial markets, operating one of the early hedge funds, and then running a multibillion-dollar turnkey asset management program for more than 40 years, I’ve formulated some thoughts on risk that I’d like to share.

First, you have to understand why risk exists. The simple answer? Because we can’t know the future or go back for a do-over.

If we knew the future, there would be no risk. Our foreknowledge would prevent us from encountering any bad events.

Similarly, if we could retrace our steps after encountering misfortune and avoid adversity, we could live life risk-free.

As some before me have noted, if we could live life looking in the rearview mirror instead of through life’s windshield, we could always achieve happiness.

But life does not accommodate us. Try as we might, we find that we cannot study, work, or research our way to a place without risk. Having friends in high places or trying to avoid people in low places won’t guarantee an existence without peril. Nor will simply ignoring the threat of danger allow us to sidestep it. As I have written before, risk is always with us.

I could stop here and warn you that all investments have risks, and if you think you can have the returns of the stock market with no downside, please leave. Take your assets and put them into money-market certificates. Then pray that neither inflation nor a plunging dollar makes your funds worthless.

Hopefully, however, I have more to say (not that I disagree with the foregoing).

Recognizing market risk

Most people seem to believe that they can recognize risk. And there are risks that you can see a mile away. You know the danger of crossing a street or stopping on a railroad crossing.

The advice of one of the owners of a market-timing firm we acquired still rings in my ears. At every seminar on timing, he would ask, “If you’re standing on the railroad tracks and a train is approaching, what should you do?” Of course, the answer is, “Get off the tracks!”

Yet, most truly scary risk, in and out of the financial markets, is not dealt with so simply.

Our variable sense of investment risk

Why does risk seem more important to us at certain times and less so at others?

One explanation is status quo bias. Our brains are wired to assume that current conditions will continue. If markets have recently experienced steep declines, investors may be inclined to see stocks as too risky—regardless of their future return potential. That perception can persist well after the downturn has passed.

In contrast, after a long period of rising prices, many investors may become more focused on returns than risk. In such environments, concerns about volatility often take a back seat to the pursuit of gains.

Another bias that works against a realistic view of risk is the familiarity bias. We encounter this bias every day. We buy popular brands. Why? Because they are familiar, they are talked about, and they are trusted. So, when stock market commentators say it’s a bull or a bear market, it becomes acceptable, and we act accordingly, giving little thought to the less popular alternative.

Silent risk

Nassim Taleb, author of “The Black Swan,” has written of “silent risk.”

Risk is often silent. By its nature, the existence of risk is not realized until it is too late. Taleb compares it to sending troops out to the battlefield after the battle is lost.

And just as we are late to recognize risk, it is impossible to measure the extent of the risk until after it has occurred. Like those caught in the path of a hurricane, we are simply left to pick up the pieces and deal with the resulting damage.

Financial risk is not predictable, but ...

The bad news is that risk can’t be predicted with certainty. The good news is that exposure to risk can be anticipated—and managed.

History shows that stock market downturns tend to follow the business cycle and occur with some regularity. What’s uncertain is the timing. A bear market could follow just a few years after the last one—or take more than a decade to arrive.

Knowing that risk is a constant doesn’t mean it can be avoided entirely. But it can be planned for. By building portfolios that acknowledge the reality of risk—rather than ignoring it—investors may be able to reduce the potential impact of the next market decline.

That’s why it’s essential to work with a financial adviser to regularly review your portfolio and ensure it’s aligned with your goals and risk tolerance. At Flexible Plan Investments, our dynamically risk-managed strategies are designed to adapt to changing market conditions—helping investors stay prepared no matter what’s ahead.