This week, we continue our discussion on risk. In everyday usage we tend to think of risk in predominantly negative terms, as something to be avoided or a threat that we hope won't materialise.
In the investment world, however, risk is inseparable from performance and, rather than being desirable or undesirable, is simply necessary.
A common definition for investment risk is deviation from an expected outcome. We can express this in absolute terms or relative to something else like a market benchmark. That deviation can be positive or negative, and relates to the idea of 'no pain, no gain'. To achieve higher returns in the long run, you have to accept more short-term volatility.
How much volatility depends on your risk tolerance - an expression of the capacity to assume volatility based on specific financial circumstances and the propensity to do so, taking into account your psychological comfort with uncertainty and the possibility of incurring large short-term losses.
Investors should seek to have a clear understanding of their risk tolerance in advance of making investment choices. Higher returns carry higher risks, and before you chase higher returns be sure your stomach can handle the higher levels of risk.