27 June 2012

How Can A Profit-Guaranteed Investment Be Risky?


Investment professionals love complicating things.
Trust me on that. I was once like that.
You don’t believe me?

The next time you meet people from the investment industry, try asking them to give you a definition of the word “risk”.

Investopedia defines “risk” as “the chance that an investment’s actual return will be different than expected...risk is usually measured by the standard deviation of the historical/average return of a specific investment.” 


Don’t get me wrong. This is actually a pretty good definition of "risk”... that is if you speak finance. But most people don’t, and if you are like most people, you probably struggled to understand even the first sentence (actual return vs expected return...huh?). Good luck attempting to measure risk!


Then, what does RISK mean?
Complicated definitions aside, many investment professionals define “risks” consistent with the above definition i.e. in terms of “uncertainty” (or “volatility”, a fancy word for uncertainty). Professionals refer to a risky investment as one with a “high standard deviation” or “high volatility” (or in our language, high “uncertainty”).

The problem is, people don’t normally think of risk that way. An investment that is “uncertain” or “volatile” may not necessarily be risky. Let me give you an example;

Suppose there is no chance of losing money on this particular investment, but depending on a certain factor (e.g. how the weather turns out to be in a year’s time), you could either make a small profit or quadruple your money, or anywhere in between. We both know that if such an investment exists, it is a no brainer – this investment has no risk (you either win small or win BIG)!

But by definition, this investment is highly risky!  Why?  The outcome is highly uncertain: you could make a small profit (say +1%) or any amount up to quadrupling your money (+300%)! Isn’t it absurd that professionals define this as a highly risky investment? 

This is how I think “risk” should be defined:  The potential for losses.

That’s it! 

Therefore, a risky investment has a high potential for losses.  An example: a share of a single, unproven company in a politically and economically unstable country. A not risky investment has a low potential for losses – like a bank account.


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This guest post was written by Ching, the founder of iMoney.my, a price comparison website for Malaysians. Ching is a CFA charter holder, and was formerly an investment consultant and wealth advisor.

1 comment:

Finance Malaysia Blog appreciates your comment. Cheers!

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