How do you measure risk in investing? Risk seems rather intuitive, in life - you know, generally, what is “risky” and what isn’t, when you see it. Balancing on a high wire would be perceived (by most humans) as risky. Sitting on your couch might be seen as a relatively risk-less experience.
In investing, what one intuits as risk and what is actually risk, though, are a bit harder to understand and not always obvious. That’s because we haven't properly defined risk. In the quest for a “metric” to properly control for risk in investing (and to justify high fees), Wall Street developed a measure we call “standard deviation”.
The general premise of standard deviation is that the more an assets price moves, up or down, the more “risky” it is. So a company which, over time, exhibits low standard deviation should, in theory, be less risky. And with less risk comes less potential reward.
By contrast, a company with huge volatility in price should, in theory, have both higher risk and higher potential for return. This makes sense in a prima facie way - a company that has the potential for huge movements (in any direction) should, in theory, have a higher potential for return.
The math, in our opinion, starts to fall apart though. Just because a company is moving up, a lot, over a few years, doesn’t necessarily make it riskier. And conversely, after a company has gone down quite a lot, in theory there should be less risk as you’re buying it cheaper (although, I hasten to add - if it went down because the business is in a death spin, then buying a falling knife ends up being a bad approach).
The whole premise of “solving for volatility” (less of it) is really an exercise of solving for human emotion, because people dislike seeing their portfolios fluctuate wildly. And solving for human emotion is important for Wall Street because ultimately, you want people to stay invested and continue paying fees (and because staying invested is ultimately best for the client - Wall Street can be self-interested and also client-focused at once). But ultimately, solving for short-term volatility is less about achieving goals and more about solving for short-term emotional concerns. If you have a “nice ride” on the market rollercoaster, you feel better about it. But if you are a long-term investor, what matters is long-term outcomes, not the day to day movements of your portfolio. What kills your total return is trading in and out on fear.
We will dig into what “risk” means in a later piece, but suffice to say that it’s our contention that measuring risk based on “standard deviation” is inadequate to the task at hand.
Overall, real estate investing makes an enormous amount of sense for long-term investors. Because it doesn’t reprice daily, you are blissfully unaware of daily price deviations. It’s really hard to sell, as well - so even if you felt a knee-jerk desire to pull the rip-cord, you won’t, because you can’t. And over the long term, it (like other financial assets) will generally march along and generate more wealth for investors (before we even contemplate tax benefits, the effects of leverage, and market specific fundamentals that can drive total returns).
In the end, true risk is less about short-term price movements and more about making sure you stay invested in assets that will grow over time. By focusing on long-term wealth generation, and by choosing investments like real estate that are less susceptible to daily fluctuations, you’re in a better position to meet your financial goals—without letting short-term emotions derail your strategy.
