The Four Types of Risk
Everyone is looking to achieve financial freedom and I’m assuming most would like to achieve it safely. Nothing is guaranteed and risk measures the likelihood of losing your investment. Conventional investing wisdom ties risk to reward.
According to the risk-reward matrix, the higher the risk the higher the reward, and vice versa. In other words, with investments where you have a low chance of losing your investment, you can also expect lower returns compared to higher risk alternatives where the chance of loss is higher but so is the potential return.
Some investors have a higher risk tolerance than others and are willing to undertake above-average risk for the possibility of higher returns. Others like to play it safe – satisfied with a fixed return if it means their capital will be safe.
In an ideal world, an investor would love to achieve above-market returns but at reduced risk. Is it possible?
To answer the question of whether it’s possible to achieve above-market returns at lower risk, let’s first examine the different types of investment risk:
Business Risk. Business risk is the risk a company will fail due to managerial and operational factors. Startups are often considered riskier than established companies because management is seen as untested and inexperienced.
Liquidity Risk. Liquidity risk refers to the ability to cash out of an investment if things go south. If you need to liquidate your holdings to access cash in a downturn, liquidity risk says you may not be able to easily find a buyer and may have to lower your asking price to motivate a buyer.
Volatility Risk. Volatility risk is tied to the broader markets, which has historically been demonstrated to be highly volatile throughout various periods. The higher the correlation of an asset to the broader market, the higher the volatility risk. A high correlation to the broader markets means an asset can lose significant value in a market crash.
Inflation Risk. Inflation risk is the risk an asset will be eroded by inflation. Putting money under a mattress is susceptible to high inflation risk because that money is guaranteed to lose value over time.
Those investments deemed to be low risk like treasuries, CDs, savings accounts, and money market accounts, are susceptible to high inflation risk if their returns fail to keep pace with inflation. Currently, none of the aforementioned assets provide returns matching the 3.1% average inflation rate over the past 20 years.
Is it Possible to Achieve Higher Returns at Reduced Risk?
Assets readily available to the investing public generally follow the risk-reward matrix faithfully. All public equities are subject to volatility and liquidity risk because of their correlation to the broader markets.
As the economy goes so too does the stock market. High-risk assets like the stock of a new company have added business risk – the risk of failure – making these stocks riskier than the average stock.
On the other end of the risk spectrum, you have fixed income assets with little volatility, liquidity, and business risk but are susceptible to inflation risk. These so-called low-risk assets can erode a portfolio if inflation outpaces its returns.
So is there an asset that can achieve above-market returns at reduced risk? Yes, but it doesn’t exist in the public markets. The right alternative assets in the private markets can mitigate the four types of business risk without sacrificing returns.
Imagine a crabbing boat out in the Bering Sea near Alaska fishing for king crab. It can be a highly lucrative venture, but also very dangerous – one of the deadliest in the country.
The reward is the same for every boat out there – the price of crab unchanged from boat to boat. However, to reduce potential loss of life, many captains will adopt a variety of risk-mitigating measures including hiring experienced crew, maintaining equipment to ensure safe and proper operation, and being in tune with weather patterns to name a few.
There are measures an investor can take to mitigate risk while maintaining above-market returns.
- Selecting a private investment with experienced management with a solid track record of success can reduce business risk.
- Private investments, by not being available on the public markets are shielded from volatility risk due to their non-correlation to Wall Street and the broader market.
- Illiquid private investments with long lockup periods avoid potential losses from liquidity risk because illiquid investments are not susceptible to the mass movements triggered by mob mentality necessitating liquidating an asset if the market nosedives.
- Private investments have historically provided annual returns far outpacing inflation.
When investing, know the four kinds of risk, but also know that by mitigating these risk factors, it is possible to achieve above-market returns but at reduced risk.