Nothing in life is without risk. And when it comes to investment risk, it is an inescapable aspect of investing and financial planning that every prudent investor must confront. Leaving your money ‘under the mattress’ as it were, putting all your funds into a ‘safe’ cash or money market account … to speculating on the latest crypto coin or meme stock all have inherent risks.
Understanding how to manage risk is crucial for crafting a strategy that aligns with your financial goals and risk tolerance. Having recently read an article penned by one of world’s most accomplished investors (Howard Marks) – this piece delves into the nuances of investment risks, categorizes investments by their risk levels, offers real-world examples, and extracts wisdom from Howard Marks himself. It also clarifies the differences between volatility and the risk of permanent loss, and outlines strategies for achieving effective diversification.
Howard Marks uses the game of chess as a metaphor to describe investment strategies, emphasizing the concept of sacrifice and risk. In chess, as in investing, strategic sacrifices are necessary to achieve long-term success. Marks describes:
• Sham Sacrifices: Comparable to buying safe assets like U.S. Treasury notes, where the sacrifice (giving up higher returns) is clear and the outcome is relatively certain.
• Real Sacrifices: Involves taking on significant risks for the possibility of greater, though uncertain, rewards.
Marks’s philosophy aligns with the famous maxim “No risk, no reward.” He argues that avoiding risk is often the riskiest strategy of all, particularly in a competitive investment environment.
Marks also highlights the psychological aspects of risk-taking, noting that a willingness to accept potential losses is crucial for long-term investment success.
Because the future is inherently uncertain, we usually have to choose between (a) avoiding risk and having little or no return, (b) taking a modest risk and settling for a commensurately modest return, or (c) taking on a high degree of uncertainty in pursuit of substantial gain but accepting the possibility of substantial permanent loss. Everyone would love a shot at earning big gains with little risk, but the “efficiency” of the market – meaning the fact that the other participants in the market aren’t dummies – usually precludes this possibility.
Most investors are capable of accomplishing “a” and most of “b.” The challenge in investing lies in the pursuit of some version of “c.” Earning high returns – in absolute terms or relative to other investors in a market – requires that you bear meaningful risk – either the possibility of loss in the pursuit of absolute gain or the possibility of underperformance in the pursuit of outperformance. In each case, the two are inseparable.
The risk inherent in not taking enough risk is very real. Individual investors who eschew risk may end up with a return that is insufficient to support their cost of living. And professional investors who take too little risk may fail to keep up with their clients’ expectations or their benchmarks.
The core principle of investing is the relationship between risk and return: generally, higher potential returns come with higher risks. Key risk types include:
• Market Risk: The risk of losses due to overall market performance.
• Credit Risk: The risk that a bond issuer or borrower will fail to meet their obligations.
• Liquidity Risk: The risk of being unable to sell an investment at a fair price quickly.
• Inflation Risk: The risk that inflation will erode the purchasing power of returns.
• Interest Rate Risk: The risk that changing interest rates will affect the value of investments.
Understanding these risks and aligning them with personal financial goals and risk tolerance is crucial for every investor.
The common way to categorize investments has been to put them into low, medium, and high-risk categories (or variations thereof). But investment risk and where investments fall on a risk spectrum (or ladder) is often a lot more nuanced – and depends on things like interest rates, where we are in an economic cycle, and overall mood or sentiment of the market (are we in a risk on vs. risk-off environment). Different investments might perform well or poorly based on some of these factors, which is why diversifying effectively remains the best strategy to optimize returns while reducing (note – not eliminating) these risks.
Further Reading: Timeless Investment Principles and Strategies To Achieve Long-Term Investing Success
When assessing the risk associated with various asset classes, it’s useful to envision them on a risk ladder, with each rung representing a step up in potential risk and return.
Historical market events highlight the real impact of risk. The 2008 financial crisis showed how complex, interconnected financial instruments can trigger global market failures. The dot-com bubble and COVID-19 volatility revealed how quickly excesses can unravel—and just as importantly, how markets can rebound and grow over time.
Equities remain the most reliable path to long-term wealth creation—provided investors exercise patience and discipline. Bear markets are deeply uncomfortable, with equity markets sometimes falling 50% or more, but history shows that recovery follows for those who stay the course.
Further Reading: How Structured Products Can Hedge Risk in a Well-Diversified Portfolio
It’s vital to distinguish between volatility risk and the risk of permanent loss of capital. Volatility refers to the temporary ups and downs in asset prices. While unsettling, these swings usually correct over time if fundamentals remain sound and investors remain patient. For instance, the S&P 500 has experienced multiple drawdowns of more than 50% yet has still delivered average annual returns of around 10% since World War II. Even Amazon, which fell more than 90% during the dot-com bust, went on to become one of the best-performing stocks of the past two decades.
Permanent loss of capital, on the other hand, occurs when investments never recover. This is often driven by investor behaviour … selling at the worst possible time … or by poor investment choices such as speculative bets or overly concentrated portfolios. A lack of diversification can magnify the damage, turning temporary setbacks into lasting losses.
Examples abound. Once-iconic companies like Eastman Kodak and BlackBerry lost relevance as technology advanced, wiping out shareholder value. Locally, Steinhoff collapsed due to fraud and mismanagement, reminding us that corporate failure remains a risk investors must factor in.
Diversification is one of the most powerful tools investors have to reduce risk. Harry Markowitz’s Modern Portfolio Theory shows that spreading investments across a broad range of securities reduces the unsystematic risk tied to individual companies. For example, holding 20 or more stocks across sectors like technology, healthcare, consumer goods, energy, and financials cushions a portfolio if one or two holdings fail.
Unit Trusts and Mutual Funds
Unit trusts (mutual funds) make diversification easier by pooling investors’ money into a portfolio that might hold 50–100 different securities across multiple industries and geographies. A balanced fund, for instance, typically blends equities, bonds, and other assets to reduce exposure to any one market shock.
Index Funds and ETFs
Index funds and ETFs also provide instant diversification by tracking baskets of companies such as the S&P 500 or NASDAQ 100. At first glance, these funds appear to spread risk across hundreds of companies. However, it’s important to recognise that many popular ETFs and indices often hold similar stocks – especially mega-cap technology firms. The S&P 500, NASDAQ 100, and even the MSCI World Index, despite their different labels, share significant overlap in their largest constituents. This can create concentration risk across seemingly diversified holdings.
In bull markets, this overlap can amplify returns, but when cycles turn, it can just as easily magnify losses. True diversification requires looking under the hood … understanding what actually drives each fund’s returns … and extending investments beyond the most common ETFs or popular unit trusts.
To build a genuinely diversified portfolio, investors should combine different building blocks:
1. Equity ETFs across multiple regions (US, Europe, Asia, Japan, Emerging Markets).
2. Exposure to different asset classes such as bonds, property, infrastructure, or gold.
3. Selective active funds or specialist strategies to capture unique opportunities not covered by mainstream indices.
This broader mix helps reduce reliance on a narrow group of stocks or sectors and creates a portfolio that is better positioned to weather different market environments.
Now Read: How Hedge Funds Can Be Used to Reduce Risk and Improve Returns in Investment Portfolios
Diversification helps in reducing the risk of permanent loss as it avoids over-concentration in any single investment or sector. It is one of the key principles of risk management in investing. By spreading investments across different assets, sectors, and geographic regions, a diversified portfolio can withstand market volatility better and recover from downturns, thus preserving capital over the long term.
This is a useful image published by Fidelity in the US that illustrates how asset allocation impacts performance and volatility. The point is the most aggressive growth portfolio (most heavily weighted to stocks) experiences the most extreme volatility (look at best-and-worst 12 month returns) – but produces the best average annual return.
The Conservative Portfolio which has a much lower stock allocation relative to bonds and short-term investments is a lot less volatile – but its average annual return is signficantly less than the aggressive portfolio.
That translates to the following end values over a 20-year investment term assuming an investment amount of $100K:
Conservative (5.75% p.a.) = $315K
Balanced (7.74% p.a.) = $468K
Growth (8.75% p.a.) = $572K
Aggressive Growth (9.45% p.a.) = $657K
Even with a gut-wrenching, stomach turning 60% fall in value for the aggressive growth portfolio along the way (and other less severe drawdowns no doubt too) – if you can withstand the volatility and stay invested through the turbulence, you give yourself the opportunity to achieve the best long-term returns.
Further Reading: Understand Our Investment Advisory Service Offering to Create Globally Diverse Portfolios to Help Mitigate Your Risk.
Investing always involves risk, but the real challenge lies in understanding how much risk you need to take to achieve your goals, how much risk you can actually afford to take, and how much risk you can comfortably live with. For some, the biggest danger is not market volatility, but the risk of running out of money in retirement because their portfolio was too conservative to keep pace with inflation and long-term spending needs. For retirees, sequence risk … the danger of poor returns early in retirement … becomes especially critical, while for younger investors, missing out on growth opportunities may be the greater threat.
There is no single “right” level of risk; it’s different for everyone, depending on goals, time horizon, financial resources, and personal tolerance for uncertainty. That’s why building a resilient portfolio tailored to your unique circumstances – one that balances risk and reward appropriately – is paramount. With a clear plan, thoughtful diversification, and an understanding of your own risk profile, you can navigate market ups and downs while staying on course toward long-term financial security.
Carl-Peter is a Certified Financial Planner® and co-founder of Henceforward, an independent wealth management and family office firm. With over 20 years of experience, he specialises in helping South African families and professionals structure resilient investment portfolios, manage risk, and plan for long-term financial security. His focus is on blending global investment opportunities with practical, client-centric advice tailored to each individual’s goals..
