Yes, new year, new acronym!! But I think this a crucial one. For years, the tenets of mainstream investing have involved buy and hold and investing based upon your risk tolerance. The mainstream is moving towards accepting the concept that buy and hold is not a winning strategy to always pursue.
Regarding risk tolerance, an aggressive investor was counseled to take more risk than a conservative investor. In mainstream portfolio management this really meant that the aggressive investor owns more equities and the conservative investor owns more fixed income. It is time to end this myth also.
First, we grant that the appetite for risk is a crucial ingredient in formulating portfolios. Someone whose goal is to grow their money at a faster rate will of necessity need to take more risk than someone who has a lower tolerance for loss or who simply does not need to grow their money as fast in order to meet their financial goals. The problem is that risk does not equal the proportion of equities and fixed income in a portfolio in a static balance. To make this traditional assumption is to totally ignore the potential reward of an investment!
For instance, Investment A has a potential loss this year of 15% of your principal. Should you make this investment? Would it make a difference to you whether the potential reward from this investment was 10% this year or 20%? It sure would to us!
The best way to understand the situation might be to look at the cost to purchase an investment per dollar of earnings. If it cost you $10 instead of $20 to purchase a dollars worth of earnings in the stock market this year, your reward is twice as large as when you have to pay double for that same amount of earnings. A rational person must include this in their calculations and be willing to adjust their risk accordingly. In order to grow money successfully, you increase risk when there is increased potential for rewards and decrease it when the potential rewards are smaller We call this……. Variable Risk Investing (VRI)! We will be writing more on this topic in coming weeks and will also have some longer essays on this idea.