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MRI Brain Scan
A college student once walked into my office, brimming with excitement. “I want to invest in Bitcoin!” he declared. When I asked why, he said, “My roommates are making so much money. They bought it last year and it has already doubled!" This type of enthusiasm is common, but troubling. One of the key distinctions between a novice and a seasoned investor is how they understand and respond to risk. This student was acting like a novice, in that the pursuit and thrill of easy money was overshadowing their ability to seriously consider risk.
But what does it really mean to consider risk?
Measuring Risk
Traditionally, investors use statistical tools to calculate risk, like standard deviation, volatility, beta, and downside deviation, to name a few.
For instance, a stock with a historical return of 10% and a 20% standard deviation would be expected to return anywhere between -30% and +50% about 95% of the time. The higher the deviation, the more unpredictable the investment.
Mature investors consider the standard deviation alongside the return potential of an investment and then aim to maximize their risk-adjusted returns. A simple way to do this would be to seek to build a portfolio that has the highest amount of return potential given the lowest amount of estimated risk. A common way to measure risk-adjusted returns is by using the Sharpe ratio. This ratio is expected return over expected risk and tells you how much return you’re earning for every unit of risk you’re taking.
But is calculating risk-adjusted returns, and properly considering the risk of an investment before you buy something, the only important factor for a mature investor regarding risk?
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