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Risk Means Different Things to Different People

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.

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Comments

  1. Mike, thanks for a great follow up post.

    I want to respond to one point. The variability of ending values in a stock portfolio decline over time. That’s because the good and bad years average out. The longer the hold time, the lower the variability of ending values. Period.

    I also wanted to respond to the points about risk and real estate. Your risk is NEVER measured by how well your neighbor does. Sure there is always someone who buys at a better time but it’s just not relevant.

    As you point out so well, risk can be measured in many ways but in my experience, the most important definition is the odds of not achieving your financial goals. So to access your risk, be clear about your priorities and invest appropriately.

    Thanks for another well thought out post Mike.

  2. Neal, I think we agree on most points here.

    But I don’t think we’re on the same page about this one:

    “The variability of ending values in a stock portfolio decline over time. That’s because the good and bad years average out. The longer the hold time, the lower the variability of ending values. Period.”

    This is simply not true–not if you’re measuring in terms of dollars anyway. (If you’re measuring in terms of annualized returns, it is true.)

    Let’s imagine I have a $100,000 stock portfolio, and I’m considering holding it for 1 year or 30 years.

    Over 1 year, it would be exceedingly rare for me to either lose or earn more than 50% of the value. Result: Possible variation in ending values is a range of approximately $100,000. Whether using historical results or MC sims, more than 90% of the results will be within that range.

    If I hold that initially-$100,000 stock portfolio for 30 years though, can we provide with any degree of certainty a $100,000-range where the portfolio’s ending value is likely to end up?

  3. This is a nice read that offers up some non-traditional approaches to defining risk. I would argue that using standard deviation of annual returns is a better metric because this is the metric that is most closely related to behavior. Investors typically don’t look back at risk from a 30-year cumulative number, they measure it in much smaller time increments. Plus, if an investor saw the difference over such long periods, they may never invest in anything:)

    Understanding 1-, 3-, and 5-year risk as measured by standard deviation is much more useful because these are the periods of time that investors are using to make decisions. Unfortunately, many investors lose site of the long-term when the market drops like a rock or rockets to the moon because they apply short-term logic to long-term goals.

    A good exercise for anyone new to investing is to look at a particular portfolio mix of stock/bonds/cash and see what the worst case scenario has been historically over 1-, 3-, and 5-year periods. Following this, ask yourself: (1) Can I withstand this kind of loss? and (2) Would I continue to stay invested through these short-term movements? If the answer is ‘no’ to either question, you must dial down the risk level or look at the steps that precede investing (health & stable income, controlled spending, appropriate insurance coverage, emergency savings) to see why you answered ‘no’.

    I know investors don’t have access to the advisor reports available through Morningstar, but on their portfolio snapshot reports, it lists standard deviation for 1-, 3-, and 5-year periods relative to a benchmark index or blended indices. Very, very useful information if you can get it.

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