Investors spend a lot of time thinking about returns. Time is spent debating performance figures, opining on market valuations, creating valuation models, and searching for opportunities.

We tend to focus far less on another important question – what risks are embedded into the decisions we make?

This is partly because risk is often misunderstood. Many investors equate risk with volatility. In this way of thinking the daily movement of an investment should be an investor’s key concern. A share price that moves sharply feels risky, while an investment with stable prices feels safer.

Volatility is only one expression of risk. For long-term investors, the bigger risks are often less obvious. Yet far more harm is done to portfolios when investors are forced to sell at the wrong time. More goals are left unachieved from being overly exposed to a single outcome.

This is not an academic argument. If investors focus on the wrong risks they are less likely to achieve their objectives. I’ve come up with three under the radar risks that far too many investors ignore.

Volatility is not always a risk

The idea that markets go up and down is hardly new. Still, many portfolios are constructed to avoid volatility instead of being designed to achieve a goal.

A falling market is uncomfortable because it creates uncertainty. A decline in a high-quality diversified portfolio may carry less uncertainty if you have a greater understanding of how each holding is connected to your financial goals.

Aligning a portfolio to a goal makes volatility an opportunity. Investors who have the liquidity, patience and conviction to remain invested can benefit from drops in the market.

Reframe the risk of volatility. The relevant question is not ‘how much can this investment fall?’ but instead ‘what happens if my investment thesis is wrong?’.

If there is a fundamental issue with your thesis, you are more likely to suffer a permanent loss of capital. This is very different from the inherent volatility of markets. Spend your time on developing a more robust thesis instead of focusing on volatility measures.

The risk of a mismatch between the portfolio and the investor

One of the most important concepts in investing is the difference between risk tolerance and risk capacity. Risk tolerance is psychological. It is your willingness to experience losses and uncertainty.

Risk capacity is financial. It is your ability to earn the return needed to achieve your goal while absorbing the volatility of assets with higher expected returns. The two are often conflated. I’ve written in detail about the difference here.

Things tend to go wrong when investors believe their risk tolerance is higher in theory than it turns out to be in practice. Conversely, an investor who has decades until retirement may be naturally averse to risk, and their discomfort with volatility may cause them to ignore their risk capacity and hold a more defensive allocation than what they should to achieve their retirement goal.

It is your job as an investor to understand how your investments connect to your financial goals. This understanding may help with holding the right investments, and with the difficult task of staying invested through volatility.

Concentration needs to be a considered decision

Many investors understand diversification in theory. However, in practice portfolios can become more concentrated than investors realise. I recently wrote about the diversification illusion and how many Australian investors are exposed to a narrower set of outcomes than they realise.

This can happen through circumstance, or naturally over time as investment performance deviates within a portfolio.

I’m an example of how circumstance can lead to concentration. I’m an advocate for diversification yet a large part of my portfolio is concentrated in one holding – Morningstar MORN. It is part of my remuneration package.

I work in financial services, and my skills and experience are aligned to the industry. With over 30 years to go until I access my superannuation, my assets are heavily concentrated in equity markets, which locally are further concentrated in financials. I have a mortgage on a property in the Australian market.

I understand the concentration in my portfolio, but also the context of my multi-decade time horizon.

Concentration can work in your favour. Many of the best investment outcomes have come from investors having meaningful exposure to exceptional businesses.

This concentration does change the nature of risk. When a portfolio depends heavily on a small number of outcomes, the investor is no longer just taking market risk. Instead, the primary risk is an investor’s ability to assess if their specific investments are correct. This is not necessarily the incorrect path - some investors deliberately make concentrated bets because they have a high level of conviction.

It is important that the level of concentration in your portfolio is a considered decision, and not something that you have drifted into without noticing.

Liquidity is an underrated source of risk protection

One of the least discussed risks in investing is being forced to act.

A long-term investor may be comfortable with market volatility but circumstances can change unexpectedly. I’ve written about the risk of income loss before. There could be an unexpected expense which your emergency fund can’t cover. A financial commitment can turn a temporary paper loss into an actual loss if you are forced to sell at the wrong time. Liquidity is an important consideration in portfolio construction and capital preservation.

Cash often has a poor reputation because of the opportunity cost. However, maintaining liquidity is not just about the highest returns. It is about retaining flexibility. Having the ability to avoid selling during difficult conditions can be valuable, particularly for investors who want to take advantage of opportunities when others are forced to sell.

I recently got an email from an investor who was grappling with this opportunity cost for an adequately sized emergency fund. He queried where I keep my emergency fund, as it feels hard to leave a large amount of cash there not working for you.

My emergency fund is in two different places. I want to ensure that I have funds that are in an individual account that is for me, and accessible only by me. These funds sit in a savings account and are always available in case of emergency. It does not have any bonus interest conditions or contribution minimums.

To make myself feel better about my cash sitting in this account, I ensure that I am only putting what is needed for four months’ worth of expenses – that is what I believe is the minimum amount necessary under multiple scenarios. One scenario is the waiting period on insurances I hold. Another is what I believe is a conservative time frame to replace my income if lost.

My offset is a joint account with my husband. As I grow my emergency fund, I put the extra funds into my offset for my mortgage. I feel better financially about the funds in my offset. My marginal tax rate payable on investments plus interest rates currently makes it a decent place for cash.

Holding cash is painful for many people and I empathise. What helps me is looking at the alternative (not being adequately self-insured) and the times in my past when I have need my emergency fund. There have been three occasions now where I have had to use my emergency fund – being in those situations is why that cash is non-negotiable for me. We’ve done some research on it as well.

Like many things in finance, an emergency fund is more about mindset than maximising returns.

This is a balancing act. Holding too much cash and inflation will eat away at the purchasing power of your money. Many people are living in retirement for as long as they work and face increased longevity risk with large cash holdings.

Avoiding all risks creates different problems. A successful investor gets the balance right between self-insurance and reaching future investment goals. Focus on developing an understanding of your financial goals to strike the right balance in your portfolio.

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