Risk is one of the most misunderstood concepts in investing. As financial professionals, we often witness how people equate risk with volatility or the potential for loss. But the truth about risk is far more nuanced and philosophical than most people realize.
The fundamental principle we need to understand is that risk functions like energy—it cannot be created or destroyed, only converted from one form to another. This perspective transforms how we approach financial decisions. When you choose to eliminate one type of risk, you’re inevitably taking on another. There’s no magical investment that offers high returns, perfect safety, and complete liquidity. If someone promises you this trifecta, you should run—not walk—in the opposite direction.
Take, for example, the person who places their savings in a “safe” high-yield savings account to avoid market volatility. While they’ve eliminated market risk, they’ve substantially increased their inflation risk. Their dollars might maintain the same nominal value, but their purchasing power could erode significantly over time. In extreme cases like Weimar Germany’s hyperinflation, “safe” bond holders were devastated while stock investors preserved their wealth because stocks adjusted to the new currency reality.
Even Warren Buffett, the investment sage himself, doesn’t eliminate risk—he carefully chooses which risks to accept. His approach of buying businesses below their intrinsic value and focusing on cash flows doesn’t eliminate risk; it merely converts certain types of risk (like overpaying for growth) into others (like liquidity risk or opportunity cost).
Understanding risk conversion is particularly important when constructing portfolios. The traditional wisdom that bonds provide safety when stocks fall was upended in 2022 when both asset classes declined simultaneously. Why? Because the risk relationship changes based on economic conditions. When interest rates were near zero and inflation spiked, bonds no longer offered the protection investors expected.
Another critical misunderstanding is the relationship between risk and return. Risk does not equal return—it equals the possibility of more return. Taking on additional volatility may improve your chances of higher returns over time, but there’s no guarantee this will happen in a linear fashion or within your needed timeframe. You’re essentially being compensated for your willingness to endure periods of discomfort.
So how should investors approach risk management? The answer lies not in trying to eliminate risk—which is impossible—but in thoughtful financial planning. By understanding your time horizons, liquidity needs, and personal comfort with different types of risk, you can make informed decisions about which risks are appropriate for your situation.
The most dangerous risk is the one you don’t know you have. Many investors focus exclusively on market volatility while remaining blind to inflation risk, liquidity risk, geopolitical risk, or longevity risk. A comprehensive financial plan addresses all these dimensions and provides a framework for making risk conversion decisions that align with your goals.
Remember that financial plans aren’t static documents—they require ongoing management as your life circumstances change. As Mike Tyson famously said, “Everyone has a plan until they get punched in the face.” Wealth management begins with planning but continues with monitoring and adjusting as needed.
The next time you evaluate an investment opportunity, resist the urge to ask simply “How risky is it?” Instead, ask “What specific risks am I taking on, and am I being adequately compensated for those risks?” This subtle shift in thinking can dramatically improve your decision-making and help you build a financial strategy that truly aligns with your goals and values.