Investment risk is a topic that’s often simplified to the point of being misleading. While it’s true that every time we aim for an investment return, we’re taking a risk, the nature of that risk isn’t always clear-cut. Many investors, especially everyday folks, may be taking on more risk than they realise.
Understanding Volatility and Traditional Risk Management
The most common form of risk we’re warned about is the potential for a negative return over a specific period. This is more accurately termed volatility, but for the sake of this discussion, let’s stick with the term ‘risk.’ It’s not uncommon to hear stories of individuals who sell off their investments when the market takes a nosedive, thereby locking in their losses. This is a classic example of conflating gambling with investing.
To manage this type of investment risk, traditional strategies like diversification are often recommended. By dividing your investments into various asset classes like cash, fixed interest or bonds, property, and shares, you’re not putting all your eggs in one basket. While diversification may limit some potential gains, it provides a safety net for your capital. Another strategy is to extend your investment timeframe. Both property and shares have historically shown that while short-term gains can be volatile, long-term investments are generally more stable and profitable.
Unconventional Risks: Custody and Currency
Here’s where I diverge from mainstream thought. I’m concerned about risks that are not often discussed, such as custody risk. Whether it’s an online sharebroker or a managed fund, these investments are not held directly; they’re held on our behalf through a ‘custodian’. While the likelihood of a problem arising is low, it’s not zero. And in a world full of uncertainties, that’s worth considering.
Another under-discussed risk is the instability of the dollar-denominated financial system. Regardless of how diversified your portfolio is, you’re still operating within a financial system that is increasingly showing signs of instability (ie bank failures).
Hedging: The Essential Safety Net
To manage these unconventional risks, I personally use of offsets or hedges. These are financial positions that can offer a significant payout under distressing circumstances, acting as a form of insurance for your portfolio. This is where alternative investments like Bitcoin, precious metals, and decentralized finance come into play. Contrary to some opinions, these aren’t speculative gambles, but can instead be strategic hedges against systemic risks.
If you’re still solely relying on traditional forms of diversification, it’s time to broaden your horizons. The future of money is changing, and as we’ll see with some digital assets like Bitcoin, they could form integral parts of the new financial paradigm.
In this podcast, I’ll be discussing these topics in detail with Michael Nadeau, founder of The DeFi Report. If you’re interested in going beyond the surface, make sure to check out the show notes and sign up for The DeFi Report newsletter.
Summary
Investment risk is not just about volatility; it’s a multi-layered concept that includes both conventional and unconventional elements. While diversification and long-term investment are effective tools for managing traditional risks, they fall short when it comes to addressing systemic issues like custody and currency risks. To truly secure your financial future, consider incorporating hedges like Bitcoin and precious metals into your investment strategy.
