In a recent guest post, the author (Neal) argued that an investment in real estate becomes less risky the longer it’s held. In the comments, two readers (Dylan and The Finance Buff) disagreed. One even argued that such an investment becomes more risky the longer it’s held.
So who was right?
As far as I can tell, they all were. They were just using different definitions of risk.
Traditional Risk Measurement
In traditional finance literature, variability (specifically, standard deviation) of annualized returns has often been used as a measurement of risk.
Perhaps the most famous example of someone using this definition is Jeremy Siegel in his mega-selling Stocks for the Long Run in which he argued that stocks become less risky the longer you hold them because (historically in the U.S.), the standard deviation of inflation-adjusted annualized stock returns has been smaller over longer periods than over shorter periods.
Variation in Total Ending Value
Others argue that risk is better measured as variability of total ending values. This definition turns the “stocks become less risky with time” idea on its head. When measured in terms of ending value, stocks (and other investments with highly variable returns) become more risky the longer you hold them because, when compounded over a few decades, even a slight difference in annual returns leads to a dramatic difference in total ending value.
Probability & Magnitude of Shortfall
Still others argue that the best definition of risk involves probability and magnitude of a shortfall–that is, the risk of not having the amount of money you need when you need it.
Using this definition, the riskiness of an investment depends on your expectations for it and on how you plan to use it. For example, even if an investment steadily delivers 4% inflation-adjusted returns every single year, it’s going to be a problem if your financial plan was relying on 7% returns.
Probability & Magnitude of Loss
Finally, it can be helpful to consider risk as probability and magnitude of loss. But, as with the previous definition, this one varies from person to person. For example:
- Are you going to experience significant stress any time you sign into your brokerage account and see that the portfolio value is lower than last time you checked?
- Or, for instance, would you be OK as long as the value is higher than it was, say, three years ago?
- Or would you be OK as long as the decline is smaller than a given percentage?
- Or would you be OK as long as the decline is smaller than a given dollar value?
Why Is This Important?
I think there are two useful takeaways here.
First, when you hear writers, financial advisors, or anyone else use the term “risk,” be aware that they could mean any of several different things. If the meaning isn’t clear, ask.
And more importantly: When assessing your risk tolerance, put some thought into what type(s) of risk you care most about. This information will play an important role in selecting an appropriate asset allocation.