Investment Risk

Risk is often characterized by volatility. But according to Warren Buffett $BRK.B this is wrong. Volatility is not risk. In a simple thought experiment, someone who invested in the S&P 500 $SPX500 is taking more "risk" than someone staying in cash. But after 30 years, we can be sure that the one who invested is richer than the one who saved. So was avoiding volatility really avoiding risk?

There are two types of investment risks: Systematic and unsystematic risks. Systematic risks are for example, that stocks will typically go down in a recession and cannot be eliminated by diversification. However, unsystematic risk can be lowered through proper diversification.

According to CAPM, risk is volatility but value investors would disagree with it. For example, my best ever investment, GameStop $GME was deemed risky if we just look at the performance of the stock. It was down 95% in a bull market and my own investment was down 60%. CAPM would not recommend such a stock. But it was not risky if we looked at the fundamentals. That's why I invested in GameStop 2 years ago. Today, CAPM would recommend a stock like GameStop since the Beta is now positive and much bigger than 1. But as a value investor, I will say that it is now a very risky investment.

To understand risk, you need to know your risk profile as an investor. For me, I have a high-risk tolerance since I can manage volatility but maybe you cannot, then you should invest in safer stocks and diversify in other asset classes such as government bonds $TLT and gold $GOLD .

Risk perception (your views on risk) and Risk capacity (how much money you can afford to lose) are also important. In fact, I believe that risk capacity is much more important than risk tolerance since you always need to look at the worst-case scenario. It is possible to invest in a stock where the probability of it going to zero is high but then the potential reward should be very high as well. What you're looking for is asymmetric risk-reward.