Overview – Is It Possible to Be Too Careful in Investing?
Part of any successful investor’s playbook is knowing how to properly handle investment risk and how to play things safe. After all, being an investor means having to deal with the prospect of potentially losing your money, so the last thing they’d want is for all the time, effort, and energy they spent to be in vain due to them being reckless.
We’ve talked about investment risk and risk management before, and how failure to understand what these things are can quickly land investors in a very sticky situation.
Although skilled investors are able to achieve strong investment returns while simultaneously keeping risk at bay, no investor wants to take on more risk than they absolutely need to. The best way to deal with risk is not to take any in the first place or to get rid of as much of it as possible.
If risk is a necessary evil that investors need to deal with, and trying to minimize the amount you take on is considered prudent, then surely there’s no such thing as being too cautious, right?
Risk & Reward: The Foundational Relationship of Investing
Before continuing, let’s take a step back and take a look at the relationship that underpins all investment decisions: risk & reward.
It’s important to remember that, at its core, investing is simply the act of putting down money today with the hope of receiving more in the future. Of course, there’s much more to it than that, but in its most basic form that’s essentially what it is.
Any time you put money down for investment purposes, there’s always the possibility of losing it because the investment operation you pursue may go bad.
Investing is all about finding the optimal balance between expected returns and tolerable risk based on an investor’s comfort level.
In centuries past an investor may have been someone who helped finance overseas business expeditions from their home country to other parts of the world. The investor helps fund the trip, and in return, they get a slice of whatever treasure or profits the expedition may gain from their journey.
If they wanted greater returns, then they can finance more expeditions, thereby increasing their chances of more successful ventures one day returning.
However, there’s always the possibility of a venture not going as planned: the trip may not be as profitable as expected, bandits may raid the ships, or a nasty storm out at sea could damage and sink the ships. If any of these adverse incidents were to happen, then an investor will have no choice but to lick their wounds and hope they recoup their losses from other, successful ventures.
Nowadays, marketable securities, commodities, real estate, and even rare art pieces serve as the primary investment vehicles for investors to choose from, yet the underlying idea remains unchanged: any time you want to put your money down today, there’s always the possibility of losing it in the process.
Generally speaking, and this is meant in the broadest way possible, if an investor wants better investment returns, then they’ll need to shoulder more investment risk as well.
For example, common investment wisdom dictates that equities have the potential to provide better returns than fixed income securities through robust capital appreciation and higher payouts, but they’re riskier because if the enterprise that offered the equity were to go under and were subsequently forced to de-list, an investor’s capital would be wiped out in the process – among other risk factors.
However, as we’ve talked about before, expected returns and investment risk are not linearly related: it’s possible for an investor to enjoy excellent returns without having to stick their necks out too far – the key to achieving this is having effective risk management procedures and processes in place.
Through prudent decision-making and proper implementation of risk management, investment risk can be kept under control, but it can never be fully eliminated – trying to eliminate it entirely is usually unnecessary and will only end up producing minimal benefits while having to shoulder enormous costs in the process.
Investment Risk Can Be Made Low but Never Zero
There’s nothing wrong with wanting to be safe when doing something: most people want to drive safely, workers who operate in a high-risk environment want adequate safety systems and equipment, and hikers don’t want to fall and sustain any major injuries.
Similarly, it’s understandable when someone chooses to be a cautious investor. Nobody wants to lose money as a result of taking on too much investment risk, so it’s only natural that many investors do their best to minimize the possibility of that outcome from happening.
While being cautious can help you avoid some potentially harmful outcomes, the reality we all live with is that risk will always be present and that the only way to avoid risk is to do nothing at all. Being cautious certainly helps, but that doesn’t mean risk can be removed entirely by simply being more cautious.
For example, no matter how defensive of a driver you are, there’s always the possibility of ending up in an accident. Being a defensive driver greatly reduces the chances of that from happening, but there will always be some risks associated with driving – some of these risks fall within your locus of control, while others don’t. The only way to avoid these risks entirely would be not to drive at all.
No matter what sort of investment operations an investor chooses to pursue, an element of risk will always be present. Even the “safest” investments such as high-quality government bonds or short-term bank certificates still have a small, albeit non-zero risk attached to them.
Most investors understand that some risk will always be present, and accept that risk cannot be reduced any further past a certain point without running into diminishing returns no matter how robust their risk management is.
However, if an investor still can’t stomach the possibility of losing their money, even if those chances are extremely small, then their only remaining option would be to not invest at all.
Being a Cautious Investor Doesn’t Mean You Don’t Take Any Risks
Investors are categorized in all sorts of ways, and one categorization that’s commonly brought up is the following: on one end, we have the “enterprising investor”, and on the other, we have the “cautious investor”.
When talking about these two types of investors, the defining trait that separates them is their approach to risk.
Enterprising investors are usually thought to have very high risk tolerances, and as a result, are willing to make riskier investment decisions. Conversely, cautious investors are characterized as being more risk-averse and are more concerned about preserving their capital than they are about chasing after outsized returns.
It’s very tempting to look at this categorization and think that these two classifications are mutually exclusive, but that isn’t the case at all.
One of the interesting things when it comes to investing is that there’s lots of overlap. Just because an investor chooses to take one stance doesn’t mean there’s no room to be flexible. There are very few things in investing that are mutually exclusive, and instead, there are lots of things that fall on a spectrum.
Just because you consider yourself an enterprising investor doesn’t mean you don’t want to keep risk on a tight leash. Similarly, just because you fall under the category of cautious investor doesn’t automatically mean you never take any risks.
Being a safe driver doesn’t mean you’re forced to always drive slowly – people who consider themselves safe/defensive drivers go on highways all the time without much issue. The key is that they know how to drive at high speeds but have mastered the ability to keep their vehicle under control. This differentiates them from reckless drivers who love to go fast but lack the skill needed to keep the vehicle under control, thereby placing other drivers and themselves at risk.
Similarly, a cautious investor can still enjoy stronger than average investment returns. This is made possible by first accepting the fact that investment risk will always be present, then by implementing appropriate risk management processes in order to keep risk at bay.
Cautious investors are still free to take on investment risks, but they place a greater emphasis on making sure those risks are kept low as possible, and to ensure they don’t spiral out of control one day. This distinguishes them from reckless investors who take on lots of investment risk but have no systems/procedures in place to try and reduce it or to keep it under control.
What Happens if an Investor Chooses to Be Overly Cautious?
Despite the reality that some element of risk will always be present, what if an investor refuses to accept this and insists on being extremely risk-averse?
One of the first things they’ll notice is that their options are going to be very limited. At most, these investors may only want to put their money into an interest-bearing savings account, government bonds, short-term bank deposits (e.g., a GIC), or a TFSA (if you’re in Canada). Anything beyond these would start to enter the realm of equities, which is “too risky” for them.
Overly cautious investors will also need to accept that their returns are going to be very minimal, and will stay that way as long as they maintain this extreme aversion to investment risk.
Remember, if you want better investment returns, then the risk you need to take on will need to increase as well. If there was a way to achieve superior investment returns while not having to shoulder more risk in the process, then everyone would have already pursued that by now.
Because the types of investments they can pursue are very limited and the returns they can expect to achieve will be very lacklustre, overly cautious investors may find it very difficult to achieve certain investment goals. Double-digit annual returns or strong yields will be very hard to achieve if an investor limits themselves to the investment instruments described previously.
Nothing is stopping an investor from choosing to take this stance, but before doing so they should fully understand what the consequences are.
Wrapping Up
One of the realities of investing is that risk will always be present. After all, the foundational relationship that underpins all of investing is the one between risk and reward: if you want to gain money, then you’ll need to accept the possibility of losing it as well.
Generally speaking, the more money you want from your investments, the more risk you’ll need to shoulder as well. Unfortunately, investment risk can never be fully eliminated, but it can be greatly reduced and contained with appropriate risk management measures – many investors accept this reality without much issue.
Now, there are many investors who’d say they’re cautious, but that doesn’t necessarily mean they’re risk-averse. It’s entirely possible for cautious investors to take on investment risk to help advance their goals, but they place a great emphasis on making sure the risk is kept as low as possible and under control.
If an investor chooses to become overly cautious and extremely risk-averse, they may quickly find themselves dealing with a very limited selection of possible investments, very low returns, and the inability to achieve certain goals.
There’s nothing wrong with being a cautious investor, but take it too far and the consequences may soon outweigh whatever benefits might have been gained.
