What is Risk?

August 08, 2013

For many people, reducing their risk is their top investment priority. Yet, in I’ve noticed that the word “risk” means very different things to different people. The standard definition in the financial world is the variance of returns. In other words, a risky investment is one in which the returns fluctuate a lot from year to year. But when most people use the word “risk,” I think they’re referring to the probability of their investment losing value.

Here’s where there’s a difference. Let’s say investment A has returns of 0% in the first year and positive 15% the next year. That’s a 15 percentage point difference so it would be labeled a more risky investment by financial experts than investment B that earned positive 5% in the first year and negative 5% the next year, which is only a 10 percentage point spread. I bet that most people would consider investment B more risky though since it lost money.

I’ve also heard “risk” defined as the permanent loss of capital. In that sense, neither investment would be considered risky as long as investment B recovered and grew in the long run. Under this definition, stocks as a whole aren’t actually very risky even though they’re very volatile in the short run and hence considered risky in the financial world. That’s because there has never been a consecutive 20-year period (at least since 1926, when we have more reliable data) where stocks lost money even after adjusting for inflation. (However, an individual stock would still be very risky since it can go to zero and never come back).

So what’s my personal definition of “risk?” I like to define it as the probability of not achieving your goals. That means putting all of your retirement money in a money market account that never loses value but also never earns more than 2% is very risky if you need a higher return to achieve your retirement goals. At that point, you’re basically hoping for a windfall like an inheritance or a lottery jackpot to bail you out. On the other hand, keeping even all of your money in stocks may not be very risky in the long run as long as the short term volatility doesn’t cause you to sell prematurely and turn a temporary loss into a permanent one.

The good news is that no matter what definition of risk you use, the solution to managing that risk is the same: stick to cash for short term goals in which you need the money within the next 5 years and diversify into more aggressive investments like stocks for longer term goals. By using cash for short term goals, you have a low variance of returns, no risk of losing money, and as long as you save enough, you’ll have enough to meet your goals.

For long term goals, diversifying with assets that move in different directions at different times can reduce the variance of returns of your overall portfolio. In the example above, if you put half of your money in investment A and half in investment B, your overall portfolio  returns would have been positive 2.5% and positive 5%, which is only a 2.5 percentage point difference and you would never have lost money over that time period. By diversifying into many different types of investments, you’re also more likely to achieve the long term return that you need to reach your goals.  So while we may all be speaking a different language, we all still end up in the same place.