Investment Risk is about the Extreme and the Unseen

When an event such as the coronavirus pandemic hits markets, investor attention is inevitably drawn to the damage that can be wrought by high impact, unpredictable episodes. This is understandable as such occurrences can have disastrous financial consequences.  I touched upon managing the risk of ruin in my post on ergodicity[i], and Morgan Housel recently addressed the tail-end consequences of risk in typically eloquent fashion[ii].  Yet whilst it is important for investors to prepare ourselves as best we can for such scenarios; we should not focus solely on the extreme, arresting, outlier happenings.  There are investment risks that we face that are small, slow and creeping – often going unnoticed –  but compound to result in unnecessarily poor outcomes.

The tail risks investors face are problematic both because of the scale of their impact and their unpredictability.  We know that they are inevitable but we are never entirely certain what form they will take.  Most of us prepare for the next ‘extreme’ market event by taking steps that would have protected us from the previous one.   Whilst incredibly painful when they occur, a combination of appropriate time horizons, sensible investment disciplines and measured behaviour means that investors can withstand most extreme events.

At the opposite end of the spectrum from these conspicuous, striking risks are those risks that cause harm through time because we are prone to ignore their deleterious impact.  This can be because they are small and incremental; taking time to grow into something material – if we ever realise, it is too late.  Or they can be risks where we are making a temporal trade-off.  We carry out actions that make us feel better now, but increase the risks faced by our future self.

Risks that we don’t notice:  The most obvious example of an often unseen risk is high investment fees. In any given day, month or year high fees are likely to seem inconsequential, if they are noticed at all.  Yet the compound impact over a lifetime of investing can be staggering.  This is far from a dramatic, extreme event but more like a slow water torture.  The risk here is that we fail to meet our investment objectives, or are materially worse off than we could have otherwise have been.  It is not dramatic, or eye-catching, and many will not perceive it as a risk during or even after its realisation.  This does not mean that it cannot be profound.

Risks that make us feel good in the present, but at a great future cost:  There is a vast array of investment activities that can fall within this category.  Perhaps the most material is a failure to begin our long-term savings early enough.  Here we are liable to make our lives better now (by having more disposable income), but worse in the future because we diminish the influence of compounding.  This risk of undersaving in our younger years is one which we may either not realise at all or fail to appreciate its magnitude.  It is particularly pernicious because assuming the risk (either knowingly or unknowingly) makes our life more enjoyable in the present.

Another prominent ‘feel good today / repent later’ risk is overtrading.  Whenever we trade in our portfolios it is likely to make us feel better; very few investors are comfortable transacting in a way that causes immediate discomfort (value investors being a notable exception).  Whether we are chasing the latest momentum trade, switching to a flavour of the month active manager or raising cash in a period of market turmoil; we are probably doing things we feel good about in that specific moment.  Yet if we work on the safe assumption that most of us are terrible traders; the aggregate impact of all those trades is likely to leave us materially worse off.  Of course, we don’t perceive this to be a risk to our long-term outcomes because with each trade we think we are improving our situation (otherwise we wouldn’t be doing it).  The risk here is not about a single large trade blowing up our portfolios (which falls into the extreme category), but the compound impact of the performance chasing, the market timing and the costs incurred.  How many of us will look back and say: “I would have been better off if I had just left it alone”?

Exposure to catastrophic incidents is certainly a crucial consideration for all investors – whether they be the general (e.g. financial crises) or the specific (e.g. frauds) – but is not only the extremes that should concern investors.  Risks that seem small and inconsequential at any given point in time, can compound to have ramifications that are just as significant.