In case you haven’t noticed from earlier posts, I have some complaints about the common use of the word “risk.”
I think I’ve finally figured out what it is that bothers me so much: We use the word “risk” to encompass several distinct concepts that should really be kept separate. For example:
- We call investing in a stock “risky” because the company might go out of business.
- We call investing in stocks via a mutual fund “risky” because the stock market is volatile.
- Long-term bonds are “risky” because they’re subject to price volatility resulting from changes in market interest rates.
- Foreign investments are “risky” due to fluctuations in exchange rates.
- Savings accounts and CDs are “risky” because inflation can consume your entire return.
In my opinion, trying to have an intelligent conversation using the word “risk” (as opposed to indicating what kind of risk) is comparable to having a conversation using the word “investments” without ever distinguishing between stocks, bonds, CDs, or real estate. In a few instances it will work, but most of the time it’s just going to cause problems.
We’re Causing Confusion
Imprecise definitions certainly make writing difficult, but more importantly they cause confusion. I think the fact that we refer to so many different concepts using the same word causes severe misunderstandings among the investing public.
[Actually, I suppose this is worse than causing confusion. When you're confused, you know it. When you misunderstand something, you're not even aware that you don't understand it properly.]
Let’s use an example. Imagine that we tell somebody “Investing in the stock market can be risky. Every few years we have a bear market, and share prices drop.”
What we mean: “The stock market is volatile. If you’re going to need your money soon, investing in the market isn’t a great idea, because you could lose your money.”
What (I suspect) people hear: “The stock market is risky. Every few years, you lose a bunch of money.”
See the difference?
We’ve made it easy for people to come to the conclusion that a decline in the market is the same thing as a loss of money, when in reality, that’s only true if you’re going to be selling soon.
And–now that we’ve convinced investors that market decline = loss of money–can we really blame them when they get out of the market after a big drop? After all, if you were thinking “Oh my god! Everyday I stay in the market, I’m losing more and more money!” …you’d want to get out of the market too, right?
Too bad we didn’t explain what we meant when we said the market was risky.
I think we could all benefit from being more precise with our wording when we call something risky.
January 29, 2009 2 comments
Here’s a few of my favorites from the week:
