When you consider the value of something – anything, from a cheeseburger to a house to medical care – you probably don’t just ask yourself, “is this thing good or bad?” You ask yourself if it is affordable, accessible, of decent quality, etc. And you have probably noticed that hardly any product or service under the sun will check all those boxes at once.
When evaluating investments, however – and especially when evaluating risk – people can fall into black-and-white thinking. They will ask if this or that investment is risky, when they should be asking how it is risky. Because there is more than one kind of risk; in fact, there are at least three important ones: illiquidity, volatility and principal loss.
Your assets don’t just magically turn into money when you need them to… but some turn into money much more easily than others. That is, they are easier to sell, or more “liquid.”
Illiquidity, then, is the opposite of that. The harder it is to sell an asset, then the harder it is to convert into cash, which can leave you high and dry if you suddenly find yourself in a tight spot.
For example, you can sell $20,000 of bitcoin much faster than a $20,000 car. So if you find yourself suddenly pinched for cash, $20k of bitcoin is more helpful than a car worth $20k. In that sense, then, you could say the car is a riskier asset than the bitcoin. That sounds silly, of course, because we all know bitcoin is very risky in other ways (more on that in a minute).
The point is that relying on either bitcoin or your car for emergency cash would be stupid, since both assets carry a high amount of risk. But the type of risk is very different for each. Illiquid assets may be hard to convert to cash, but they also tend to have more stable prices… which brings us to the most well-known type of risk.
Price never, ever stays static. Whether for a bitcoin or a 10-year bond or a gallon of milk, prices are always moving up or down over time. But the slow creep of a bond is very different from the whipsaw movements of cryptocurrency. That difference is volatility, or how much the price moves over a given period of time.
The more volatile an asset is, the more likely its price will move quicker than investors do – meaning they can both make and lose a lot of money on that asset quickly. Volatile assets are therefore both more intimidating and more attractive to investors, and this is why we often speak of risk and return going hand in hand.
But while dramatic price lurches are the most obvious manifestation of risk, they are not the only thing you have to look out for. Too often, investors get hung up on volatility and forget about other, sneakier dangers. As we have seen, illiquidity is one of these – but there is another as well:
Whenever you invest, you put a certain amount of money into some asset or resource with the hope that it will make you more money in the future. That initial amount is called your principal, and it serves as the foundation of any investment – from a stock portfolio to a piece of beachfront property to a graduate degree.
Now consider an analogy: if a hailstorm breaks some windows in your house, that is a bummer but hardly irreparable. If termites or flooding ruin the foundation, on the other hand, that is much more serious – it may even bring the whole building to the ground if you do not act fast. Because investment gains grow cumulatively upon each other, principal loss can have a similar effect.
The ways that principal loss can happen are as diverse as investments themselves, but one of the most visible examples is depreciation. This is when an asset naturally loses value over time, rather than just declining in price. Physical assets like vehicles or machinery are most vulnerable to depreciation, making this risk especially important for business investors to keep an eye on.
Can you avoid risk?
Longtime readers will be unsurprised by my answer to this question: nope. Investment risk takes many forms; and contrary to what some pundits and influencers say, you cannot avoid them all. You can only make trade-offs between them.
But this is not meant as doom-and-gloom pessimism – just the opposite, in fact. If there is no magic cure for risk, then we as investors need not freak out over trying to find one. We need only look at our individual priorities and goals, and use that to decide what kind of risks we are willing to take.
That sounds a lot easier to me.