The finance community and financial services industry most commonly define “risk” as variability of annual returns.
I’ve never much liked that definition.
For example, in my retirement portfolio, I don’t care in the slightest what happens on a year-to-year basis. I’m much more concerned with what my annualized return will look like over the next 30 years. So why on earth would I measure risk as the variability of annual returns?
When I first read Jeremy Siegel’s Stocks for the Long Run, I enjoyed it tremendously. Rather than looking at variability of annual returns, he looked at variability of inflation-adjusted returns over various periods, thereby allowing an investor to glean some information as to how predictable stock and bond returns tend to be over the applicable time horizon. Perfect!
[Side note: What he found was that over periods of 30 years or more, bond returns are actually less predictable than stock returns. The conclusion, therefore, is that for anybody more concerned with 30-year periods than 1-year periods, stocks are safer than bonds.
Many people have pointed out that Siegel's analysis only looks at the U.S. and only over a period of explosive economic growth. That's true. So it's possible that his conclusions are invalid. But at least he was measuring the right thing.]
Risk is personal.
While Siegel’s definition of risk is perfect for me, it might not be the best measure of risk for you.
For example, I might say that, for an investor with a 30-year time horizon, an investment is safe if it’s likely to earn a predictable return over that 30-year period.
But what if the investor in question is the type who’s likely to be scared by a decline in value at any point over those 30 years, even if the return over the entire period is fairly predictable? Well, then perhaps my “safe” investment isn’t safe for that investor after all.
What scares you?
I think most investors would do well to spend some time thinking about what it is that really scares or upsets them when they think about money.
Does it bother you every time you see your portfolio value go down? Then perhaps you should measure “risk” as probability of loss. (And for the period in question, use the frequency with which you check your portfolio.)
Are you scared of outliving your money? Then perhaps you should consider “risk” to be the variability of returns over periods equal in length to your current life expectancy.
Does it frustrate you to no end when everybody else seems to be making money, but your portfolio is lagging? Then perhaps some version of tracking error would be a good measure of “risk” for you.
Until you know precisely what it is that you’re trying to avoid, there’s no way to know what’s safe and what’s risky. (And you can’t rely on other people’s statements on the matter, because their definition could be different from your own.)
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For me, risk is being unable to achieve my life goals. Anything that gets in my way of doing that, is risky. Sometimes, that means being very conservative is risky.
Maybe I’m not saying anything original or profound (or even correct), but it seems to me that instead of using the loaded word “risk,” one could say there are two, probably uncorrelated ways you can look at the direction of an asset over a given period of time:
1) There are factors that could cause the value of the asset to rise (increase in market value, interest, etc.) or to fall (decrease in market value, taxes, fees, inflation, etc).
2) These factors may be relatively predictable or relatively unpredictable.
So for instance:
If money is put into a Roth IRA, its value could rise or fall depending on the investments chosen. But the tax factor (under current law) is eliminated.
If money in a traditional IRA is deposited into a Vanguard index fund, again its value could rise or fall. But while the tax factor is guaranteed to reduce the value of that money when it is distributed, the loss of value from fees is greatly reduced over putting the same money into a high expense ratio, loaded managed fund.
If money is put into an FDIC-insured CD locked at 2.5% for two years, its nominal value can be predicted to increase by that percentage. But the inflation factor, which is not guaranteed but highly likely, could erode the actual value of those funds over the same time period.
It seems to me that if you analyze the characteristics of each asset or asset class along these lines, you can make the best choices for where to put your money. And you can recognize which of these factors you can control (by reducing fees, diversifying, rebalancing, etc.) and which you can’t (market volatility, inflation, etc.).
Neal: I’m on a very similar page there.
Larry: Makes sense to me. I’m in complete agreement that we’d be better off if we used more precise terminology rather than just using the word “risk” to describe a whole myriad of various measurements and phenomena (without even taking the time to mention which one we’re speaking of!).
I think you’re spot-on in that one of the best things investors can do is focus on what they can control rather than what they can’t.
I buy that variability of returns is probably the best definition of risk we have available (not perfect, just less bad than the others); however, I think the current tools used to measure volatility are inadequate. In order for standard deviation to be meaningful, market returns would have to be normally distributed. Problem is, they aren’t. Market returns are actually a Levy distribution. So current measurements of risk are at best gross oversimplifications of reality, hence things like 2008 happen.
I have to agree that not meeting your financial goals is a definition of risk. But getting there may be risky, too: losing a job, black swan events, etc. And there is per investment risks: credit risk, reinvestment risk, tax risk, etc. So there really is no encompassing definition of risk except “the action engaged may not turn out the way you expect”.
Know all the sub risks of something (like an investment or goal), try to estimate the probability of each one occurring, then decide whether to proceed, mitigate the risks you can control, or change course.
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