You’ve probably heard the saying, “You’ve got to risk it for the biscuit.”
The general sentiment is true; to have a competitive return you have to assume an inherent level of risk. It’s a natural phenomenon to “risk it” when either: you have biscuits to spare, or you have the time to make more biscuits. The issue “baked in” risk is when you begin to run out of biscuits and the time necessary to make them.
Types of Financial Risk
I hate hammering an analogy too hard but there are a few concepts you knead to know:
- Risk is an umbrella term, there are many different types: Market, Inflation, Business Failure, Legislative, etc. Is this bad? Not necessarily, it’s just a reality.
- Volatility is often used to describe risk, but it’s really a measure of how large and fast prices can change. Experts use the phrase “max drawdown” to help measure for a client what the downside risk of the portfolio will be to help create a framework for the client on how volatility could affect their portfolio.
- Beta is the measure of the volatility of an investment compared to the market. The market’s beta is 1.0. If a portfolio has a beta of 1.1 for example, the portfolio is 10% more volatile than the market.
I hope that makes sense, and that’s the end of the technical jargon: let’s get back to biscuits.
The Biscuit-Making Process of Financial Management
As we return to our biscuit analogy, it becomes evident that managing risk is akin to knowing how many biscuits you have and how quickly you can bake more.
Each type of risk represents a different ingredient in the recipe of financial management:
- Market risk is like flour, subject to external conditions and market fluctuations.
- Inflation risk is the baking powder, quietly rising over time and affecting the overall outcome.
- Business failure risk, the eggs, is the core of your investment, vulnerable to cracks if not handled with care.
- Legislative risk, the seasoning, adds unexpected flavors that can either enhance or diminish the taste.
Understanding these risks is not a sign of impending doom, but rather a practical approach to financial planning. Volatility, which measures how swiftly prices can change, is a crucial metric. Imagine it as the heat in your oven – too high, and your biscuits might burn; too low, and they’ll never rise.
Beta, on the other hand, is the secret ingredient. It tells you how your portfolio’s volatility compares to the overall market. A beta of 1.1 means your portfolio is a tad higher than the market average.
In essence, a successful financial strategy involves maintaining a balance between risk and reward. Remember, it’s not about avoiding risk altogether, but about knowing how to bake biscuits that can weather any storm.