Low-Risk vs. High-Risk investments

Risk is absolutely fundamental to investing; no discussion of returns or performance is meaningful without at least some mention of the risk involved. The trouble for new investors, though, is figuring out just where risk really lies and what the differences are between low risk and high risk.

Given how fundamental risk is to investments, many new investors assume that it is a well-defined and quantifiable idea. Unfortunately, it is not. Bizarre as it may sound, there is still no real agreement on what “risk” means or how it should be measured.

Academics have often tried to use volatility as a proxy for risk. To a certain extent, this makes perfect sense. Volatility is a measure of how much a given number can vary over time. The wider the range of possibilities, the more likely some of those possibilities will be bad. Better yet, volatility is relatively easy to measure.

Unfortunately, volatility is flawed as a measure of risk. While it is true that a more volatile stock or bond exposes the owner to a wider range of possible outcomes, it does not necessarily affect the likelihood of those outcomes. In many respects, volatility is more like the turbulence a passenger experiences on an airplane—unpleasant, perhaps, but not really bearing much of a relationship to the likelihood of
a crash.

A better way to think of risk is as the possibility or probability of an asset experiencing a permanent loss of value or below-expectation performance.
If an investor buys an asset expecting a 10 per cent  return, the likelihood that the return will be below 10 per cent  is the risk of that investment. What this also means is that underperformance relative to an index is not necessarily risk. If an investor buys an asset with the expectation that it will return 7 per cent  and it returns 8 per cent , the fact that the S&P 500 returned 10 per cent  is largely irrelevant.

A high-risk investment is one for which there is either a large percentage chance of loss of capital or under-performance—or a relatively high chance of a devastating loss. The first of these is intuitive, if subjective: If you were told there’s a 50/50 chance that your investment will earn your expected return, you may find that quite risky. If you were told that there is a 95 per cent  percent chance that the investment will not earn your expected return, almost everybody will agree that is risky.

The second half, though, is the one that many investors neglect to consider. To illustrate it, take for example car and airplane crashes. A 2019 National Safety Council analysis told us that a 
person’s lifetime odds of dying from any unintentional cause have risen to one in 25—up from odds of one in 30 in 2004. However, the odds of dying in a car crash are only one in 107 while the odds of dying after being struck by lightning are minuscule: one in 138,849.

What this means for investors is that they must consider both the likelihood and the magnitude of bad
outcomes.

By nature, with low-risk investing, there is less at stake—either in terms of the amount of invested or the significance of the investment to the portfolio. There is also less to gain—either in terms of the potential return or the potential benefit bigger term.

Low-risk investing not only means protecting against the chance of any loss, but it also means making sure that none of the potential losses will be devastating.

If investors accept the notion that investment risk is defined by a loss of capital and/or under-performance relative to expectations, it makes defining low-risk and high-risk investments substantially easier.

Investopedia