This is a follow-up to the previous post: Volatility vs. Risk
What’s your definition of risk? Please, actually take a few seconds to think about it and come up with an answer.
Most people I’ve asked define risk as “the chance that I’ll lose money.” Seems like a reasonable definition. (Not my favorite, but reasonable nonetheless.) The problem is that when people actually use the word risk, they’re usually using an entirely different definition.
Example: “I’m very risk averse.”
If risk = chance of losing money, then this statement means “I really don’t like losing money.” Well, duh. This statement would be true for nearly everybody. It would be true for so many people, in fact, that it would be totally meaningless.
But it’s not meaningless. Not everybody would describe themselves as risk averse. Why is that? It’s because when we’re talking about risk aversion (or risk tolerance, or risk/reward analysis), we’re not talking about risk at all. We’re talking about volatility.
“I’m very risk averse” doesn’t mean “I hate losing money.” It means “I’m not comfortable with volatility.”
Why is it such a big deal that we use the wrong word sometimes? After all, in our everyday conversations we often use imprecise words, but we generally get our point across just fine. So why does this one instance matter so much?
Because it scares people into making poor decisions.
When we use the word “risk” to describe something that is volatile (but not actually risky), we’re spreading misinformation. We’re spreading fear. We unnecessarily scare people into thinking that a diversified stock fund (index or otherwise) is risky, when–for investors with many years to go–it’s only volatile.
Even worse: When we use “risk” to describe volatility, what are we really saying? Well, if we use common definitions of risk and volatility…
Risk = “Chance to lose money (permanently)” Volatility = “Chance that price will temporarily bounce up and down a lot”
…we’re quite literally equating temporary downward movements in price to permanent losses in value. We’re teaching people (ourselves included) that when our portfolios temporarily decline in value, we’ve actually lost money. No wonder people panic and pull their money out.
Let’s stop spreading misinformation. Let’s stop spreading fear. If something isn’t risky, let’s not call it risky.
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