The concept of risk, or the possibility of suffering loss, has fascinated people for centuries. It is believed that study of the notion started in earnest during the Renaissance, and one of the earliest practical applications of risk involved pricing insurance for cargo ships in the 17th century.
At about the same time that Jan van Riebeeck set foot at the Cape, Blaise Pascal pondered a challenge that led to the discovery of the modern theory of probability, which assists in putting a value on the likelihood of a prediction coming true. The puzzle Pascal solved was to figure out how to divide the winnings between two gamblers after their game was stopped prematurely and one player was ahead.
The concept of mean reversion occupies the minds of many market followers, from chart-watchers to those who apply value investing techniques. For example, investors often look for shares that have moved far away from their normal trend or long-term average value, and then try to ascertain if and when they are likely to return there.
The idea is that things tend to return to normal over time, and that the further shares move from their mean or average, the more money investors stand to make as shares revert to performing normally.
Mean reversion was discovered 130 years ago. But it was a mere 50 years ago that the benefits of diversification, or dividing your investments between different types of shares and other asset classes as a way of reducing risk, was proven mathematically. Much time has been spent on proving to us exactly how many shares we need in order to diversify away different types of risks in our portfolio.
The general rule seems to be that you need fewer large cap shares to reduce risks that are specific to the shares, and more in the case of smaller companies. This makes sense, as larger companies tend to be more mature and to perform in line with macro-economic trends while smaller companies usually have more unique qualities that make them truly different.
To confuse the issue of risk even further, most of us know of at least one person who became wealthy by taking one huge risk and investing in just one type of investment, often his or her own business ... but then we know of a hundred others who failed doing the same thing.
The lure of the tiniest probability of a Tiger Woods in all of us (or, even better, in one of our children) when we swing a golf club or of a Charlize Theron in a wannabe actress, makes us blind to the true nature of chance.
That brings me to investment risk and self-knowledge. Investment risk can be broadly described as the relative smoothness of the path to your goal and whether you actually get there in the end. One can also summarise investment risk as volatility of returns and the risk of capital loss, or insufficient returns when measured against requirements.
For many fund managers, there is a third element: the risk of performing differently from the managers with whom they compete for business, and the subsequent risk of losing clients.
All three of these risks may result in behaviour that could hamper an investor achieving his or her long-term goals, and it is crucial that you are aware of them. Over the next few weeks, I will be exploring questions that may help you understand your relationship to investment risk.
An important facet of risk is to understand how you are likely to respond when your investments fluctuate more than you expected, when you lose money on an investment, and when your investments behave differently from everyone else's. It is how you respond to risk-related events that can make or break your investment plan.