Some investors think of risk like a contagious disease. Risk is something to be avoided, neutralized, hedged or minimized. Investment firms trumpet their “risk management” departments and strategies for reducing volatility.

But here’s a little secret: not only is risk unavoidable, but it’s also a key building block for generating investment returns. No risk, no return (or only the bare minimum “risk-free return”). In an environment of perfect information and zero uncertainty, there would be little in the way of investment opportunity or unique advantage (“alpha”).

The real challenge for investors isn’t eliminating risk entirely. Rather, it’s understanding the level of risk you’re taking on and distinguishing between risks that matter a lot, risks that may matter a little and perceived risks which may actually be opportunities in disguise.

Risk and Volatility Aren’t the Same Thing

Modern financial theory often equates risk with volatility (e.g. “beta”) – prices moving higher or lower. Often, stock prices or asset values which fluctuate dramatically are seen as “risky,” while those that stay flat or operate within a narrow range may be considered “safer”. That’s not always true. Volatility measures movements in price or value. True risk reflects the likelihood of permanent loss. Those are very different concepts.

In our world, when the value of an apartment declines 10% following a spike in interest rates, there’s volatility, which is tough to control. That’s very different from the apartment building across the street which is financed with excessive leverage which forces a distressed sale – that’s risky. The former is uncomfortable. The latter may be existential.

Investors who conflate volatility and risk often make poor decisions, like rushing to sell good properties during periods of temporary turbulence. A steady hand on the tiller and a patient mindset help take emotions out of decision-making and temper volatility – ultimately reducing risk over the long haul.

The Most Dangerous Risks: Those You Don’t See

Think of risk like an iceberg. It’s not the tip that’s visible above the surface that should most concern you; it’s the much larger piece hidden beneath the surface that can sink you.

True investment risk rarely arrives dramatically. It doesn’t announce itself with flashing lights or ominous headlines. Instead, it creeps in quietly through assumptions which feel reasonable at the time. Like Hemingway wrote about how bankruptcy happens in “The Sun Also Rises” – gradually, then suddenly.

That’s why we build pro forma analyses when we acquire a property which include sensitivity analyses. What if rent growth is just 2% instead of 4%? What if exit capitalization (cap) rates are 5.5% instead of 5.0%? What if renovation costs are 120% of budget? By modeling various scenarios, we better understand downside cases making us less prone to nasty surprises. Sensitivity analyses mitigate risk in the sense that they help you think through various scenarios up-front to reduce unpleasant surprises.

As we enter our 20^th year in business, we reflect on a few market cycles we’ve navigated: the Great Financial Crisis (2008-2010), the Pandemic (2020-2021), periods of spiking inflation (2021-2022), rapidly rising interest rates (2022-2023) and “pencils down”, when Pathfinder and many other disciplined investors did not transact (spring 2022 to fall 2024). We also recall a few widely understood truisms, many of which proved to be canards, including:

“Don’t worry, interest rates will remain low.”
“Aw, liquidity will always be available.”
“C’mon, cap rates only move in one direction.”
“We’ll always be able to refinance.”

Trees don’t always grow to the sky. Markets – like tides – ebb and flow. Risk is always present, even if it’s not visible or apparent.

While the future rarely behaves just like the recent past, we can learn from prior cycles. Markets shift and many asset classes – including real estate – can be cyclical. Interest rates rise and fall. Supply can spike or fall and demand can also shift.

Ironically, many investors feel more comfortable when stock prices or asset values are at peak levels since they’re in good company. Ironically, these are often the more dangerous times when risk is most concentrated. In stable periods and especially when values are rising, investors feel confident. This may cause them to take on more leverage and other risks. That leads to conditions of fragility.

Conversely, when values are falling or at low levels, investors may feel dispirited or lonely. They’re loath to double-down or to take on additional risk or leverage. Ironically, that’s generally the best time to do so since the entry point is lower and margin of safety (a timeless concept popularized by legendary investor Benjamin Graham) is higher.

Leverage: Risk’s Favorite Multiplier

Leverage is neither good nor bad – it simply amplifies outcomes on the upside or the downside. When everything is moving right along or prices/values are moving higher, the highly levered investor couldn’t be happier. When markets are moving in the other direction, the feeling is the opposite. Leverage magnifies outcomes: small misses can have large consequences. We’ve observed that investors who are aggressive in their use of leverage are often also aggressive about their operating assumptions and flimsy when it comes to building in cushions – like sufficient property/casualty insurance and adequate contingencies for construction cost overruns. Similarly, investors with a predilection for stretching limited equity with excessive debt often also prefer floating rate debt to fixed rate debt (the former can be less expensive and is generally available at higher leverage) and unwilling to pay a premium rate for a longer loan term – causing them to be caught short in down market cycles.

Investor Mindset Plays an Outsized Role

Each investor brings his or her personal biases and experiences to the party. Some investors are naturally fearful, others exceedingly greedy or overconfident. Great investors are unemotional, with ice water in their veins. They behave with the same discipline in good and bad markets alike. They are intentional about decision-making, consistent about the size of investments and thoughtful about portfolio construction and diversification. They also are disciplined about using risk mitigation strategies like sensitivity analyses, insurance and cost contingencies.

As Warren Buffet famously said, “buy when others are fearful, sell when others are greedy.” Hedges and derivatives can offload risk but there are generally no better hedges than patience and a steady temperament.

Playing it Too Safe is Also a Form of Risk

A ship is always safest in the harbor but that’s not what ships are built for. Similarly, an investor can invest 100% in cash (treasury bills, bank CD’s or Money Market Accounts). But, over time, inflation may eat up these “risk-free” returns, leaving the investor’s capital impaired. That’s why a well-diversified portfolio often has shorter- and longer-term investment horizons and investments with more and less risk (and by extension, higher and lower return profiles).

Like the ship which never leaves the harbor, the investor who stays entirely in cash is guaranteed to see his principal erode over time. And the investor who tries to time the market – buying when he thinks it’s a low and selling when he thinks it’s a high, usually doesn’t fare as well as the investor who remains invested through market cycles. Waiting for the perfect moment rarely works over the long haul. Risk mitigation strategies are appropriate but those seeking to avoid risk entirely often have a roadmap that causes them to miss out on opportunities. Astute investors do not seek to eliminate risk entirely but rather to choose which risks are worth bearing, which ones should be avoided, and which signal misunderstood opportunities.

Complacency Can be Risky

Extended periods of good times can lead to complacency, which can cause less experienced investors and operators to take on more aggressive postures – which can have disastrous consequences. We see that in economic cycles and in markets.

It is said that tough times create strong leaders, strong leaders bring about good times, good times lead to weak leaders, which bring about tough times. There’s a similar dynamic with markets and investors. Challenging times create investment discipline, leading to strong long-term performance. Good times (think easy money) can lead to undisciplined, even dangerous decisions (excessive leverage, overly rosy assumptions), producing poor investment results.

When things feel easy, investors can become complacent. What follows can be transaction volumes and pricing hitting record levels – and it’s in these moments that risk may be elevated. When the environment is challenging, financing is scarce and good opportunities are hard to find. At these moments, transaction volumes and pricing are falling or hitting new lows and astute investors take this as a sign that there may be opportunities to find value, to buy well.

In the wake of the rapidly rising interest rate environment of 2021-2022, we experienced a couple of lean years when transaction volumes plummeted and few acquisitions made sense. As noted above, we were “pencils down” from spring, 2022 through fall, 2024. The multifamily investment market began inflecting about 18 months ago and we’ve made five acquisitions since then.  The interest rate and operating environment today is rather different from just 18 months ago and our mindset about acquisitions reflects that shift.

Risk is not about predicting storms. And the ship was not intended to spend its life in a safe harbor, though that’s a comfortable feeling in rough weather. We build ships to survive rough conditions and recognize that stormy weather can create memorable voyages – and opportunities.

In investing, the goal should not be avoiding uncertainty or risk, which will always be with us. It’s learning how to navigate in and profit from it.

Mitch Siegler is Senior Managing Director of Pathfinder Partners. Prior to co-founding Pathfinder in 2006, Mitch founded and served as CEO of several companies and was a partner with an investment banking and venture capital firm. He can be reached at msiegler@pathfinderfunds.com.