The Meaning of Risk

Countless words have been writ about risk. The topic grows in popularity when markets crash (avoidance), and fades when markets rise. Then, when markets hit new highs, risk becomes popular in another way – people embrace it.

Most of the definitions of risk are of limited usefulness. Technical definitions talk about volatility, components of return, and so forth, but depend on assumptions that can blow apart when markets change suddenly. Meanwhile, the media has brainwashed investors into believing that taking more risk means more return.

It’s not that simple.

What does risk really means to the lay investor who has limited funds and is trying to achieve or maintain a certain lifestyle with his investment program? We explain it this way: risk is the possibility that you will have to make a change to how you live your life in the short term in order to obtain a certain goal in the long term, ‘long term’ being perhaps useless to you in that it exceeds your lifetime. In other words, you could be forced to make a short term sacrifice to no good end. This is the ‘losing’ side of risk, and it happens every day.

An investor who has a portfolio allocated 50/50 between stocks and bonds wants ‘more risk’ now that the market is up but also wants to retire in five years or less. He thinks that increasing his risk will get him to his goal faster. Instead, moving to 70% stocks increases the probability that he will not achieve retirement in even five years. If the market corrects like it did in ’08/’09, it could be five years before he’s recovered his value, let alone earned more.

Higher risk is not consistent with short term goals. Those goals must ‘give way’ to achieve the longer term benefit.

Stay tuned for our next entry, which will discuss getting paid for the risk you are taking.