What is Risk?
Risk is a tricky concept to pin down in the investing world. There’s no good definition of what it truly is, or how people relate to it.
And it’s – by far – the most important concept in finance.
Finance isn’t alone in not being able to define key concepts though – go ask a physicist to define time. They’ll probably say something about entropy, causality, or the arrow of time (which is the rough analogue of saying, “Risk is risk because it’s risky”), but they don’t really have a good way of explaining what time is. These fundamental concepts that everyone just kind of “gets” are surprisingly difficult to precisely explain.
But it’s important to work through what risk means – both generally and specifically to you. The better we understand the concept, the better we’ll understand what risks the market will pay us to take on and how it will do so – and what that means for how you should invest.
Most people think of risk in terms of the variance of their investments – how much they wiggle up and down on the performance charts. Variance, or as it is more commonly shown, standard deviation – is a pretty good proxy for risk, especially of the short-term variety. But it’s not risk itself – just like an apple falling out of the tree isn’t gravity itself – and it even falls short as a proxy in many circumstances.
Let’s look at an example.
Let’s say that we have two investments: A and B. Investment A has an average return of 10 percent and a standard deviation of 15 percent. Investment B has an average return of -10 percent and a standard deviation of 0 percent.
From a pure standard deviation standpoint, investment A looks riskier. But from a broader, more practical viewpoint, investment B is clearly a greater risk. Investment A is much more likely to help you reach your investment goals than investment B. Investment B may be more predictable, but it’s increasing the risk of your total portfolio.
Others have tried to define risk in terms of a security’s expected return. They say the risk is the difference between the actual return and the expected return. This falls apart because it’s circular – risk comes into play in two ways. A security’s expected return is defined by its exposure to (certain types of) risk, and then risk is the chance that you won’t get your expected return.
This doesn’t work. Like standard deviation, this can be a useful way of thinking about risk, but it’s not risk itself.
I think the most appropriate (though still not quite right) way to think about risk is as the chance that things won’t work out – that you won’t be able to meet your objectives.
Going back to that standard deviation example, investment A has a positive expected return and could potentially help you get where you want to go, and investment B is the equivalent of throwing away money. This latter route is not going to help your reach your investment goals, no matter how flat its standard deviation promises to be.
If risk is the chance that things won’t work out, then it must be defined individually. How you experienced the tech crash, great recession, or recent bull market is unique. It’s different from how your friends, neighbors, and (probably) even your spouse experienced them.
If risk is defined individually, then it must be valued differently as well. This is where it gets interesting.
Since everyone values risk differently, we all demand different levels of expected return from different assets. You may be more nervous about small company risk than I am for some reason, so you wouldn’t be willing to pay as much for a share of a small company’s stock as I am. You demand a higher expected return if you’re going to invest in something that makes you as nervous as a small company.
Everyone puts in their two cents. Everyone trades on their idiosyncratic risk preferences. Then the market does what it’s best at – incorporates loads of disparate information – and figures out the prices that everything will clear at (implicitly coming up with everything’s expected returns).
Your task is to figure out which risk factors with positive expected returns make sense to you (and in what amounts) based on how the market has priced them. The answer is going to be slightly (or not so slightly) different for everybody. It’s based on how you think about risk relative to the average market participant. In other words, your asset allocation should be based on how you are different from the average investor in the market.
What Makes You, You?
Let’s back up and look at how you might be different from the market. A quick note: I’ll be speaking in broad, sweeping, generalizations here. Your personal situation overrides everything, but I can’t speak to everyone’s unique circumstances in a blog post, so we’ll have to make do with a broad brush.
If you’re reading this, you are probably either in retirement or somewhere in the process of preparing for it, and maintaining your desired standard of living is your most important financial goal. For you, risk is not being able to fund that standard of living in retirement. Anything that makes reaching or maintaining that more likely reduces your risk, and anything that makes this less likely increases your risk. Everything else is just details.
You’re different from the average market participant in several ways, but I just want to focus on two: time horizon and inflation risk. You likely have a much longer time horizon than the average market participant, and you are probably much more exposed to inflation risk.
These two broad differences can tell us a lot about what a “typical” retirement-focused investor “should” look like.
What Time Horizon and Inflation Risk Say About You
Your exposure to inflation risk suggests that you could probably use a little higher exposure to assets that protect you from inflation. These include inflation-adjusted securities (like TIPS) and short-term nominal bonds. You may also want to consider a slightly higher stock allocation since stocks provide long-term inflation protection (albeit very noisy at times), though there’s a lot more going into the stock/bond decision than the relative weights of different asset classes in the bond portion of your portfolio.
Your longer time horizon suggests that you would weather short-term volatility better than the average market participant, and therefore might be comfortable leaning more heavily on risk factors that provide a positive, long-term expected return – namely size, value, and profitability factors. In other words, as a long-term investor, you are likely to be more comfortable taking a higher level of risk than the market.
All of this is incredibly high level though – that’s why typical and should were both in scare quotes. Everyone’s risk preferences are their own. There are no universal wrong answers – just a whole lot that are wrong for you. Your job is to figure out what risk means to you and what that means for your asset allocation.
We may not be able to precisely define risk, but we know it when we see it. And everyone sees it differently. What matters is how you deal with risk and how you are different from the average market participant. This is the key to determining your appropriate asset allocation.