7) What Does Risk Mean?

A common question in the investment world is, “how much risk are you comfortable with?”

Risk is a very complex and nuanced subject. A standard definition of risk is variation/volatility of investment returns as presented in modern portfolio theory.  The riskier the investment the more its returns will fluctuate versus a risk-free return of an investment such as a United States Treasury Bill.

Modern portfolio theory also assumes the riskier an investment, the greater the potential returns.  This seems logical if we look at long-term returns for equities (stocks) whose returns can be variable from year-to-year and average around 8- 10% per year versus fixed income/bonds whose returns are less variable from year-to-year and average around 4% per year return over long holding periods.

Relying on variation/volatility of returns as a definition of risk can be problematic. The safest and least risky form of investment, based upon the notion of lowest variation/volatility, could be stacks of money stored under your bed. Every day, every year, every decade, there would be no change in the face value of the money- no variation/volatility.  But this could be very risky.  Yes, there is the risk of thief, but a more insidious risk is the risk of loss of purchasing power.

Over a long period of time, the face value of money will have much less purchasing power because of inflation.  Think of what things cost 50 years ago such as homes, automobiles, and other goods.

In my view, a more useful definition of risk is “permanent loss of capital or purchasing power.”  Using this definition, fixed income -savings accounts and bonds can be risky investments especially in an inflationary (rising price) environment.

Some may say, “look what happened in the Great Crash/ Depression of 1929 when it took 25 years (10 years if dividends are included) to recover and more recently the

Great Recession of 2008/2009 when stocks lost 60% of their value-it could happen again.”

There have been many market Manias and Bubbles in the past, (Holland – Tulip Mania, South Sea Bubble, Florida Land Bubble, 1960’s Technology Bubble, 2000 Internet Bubble, 2008 Real Estate Bubble) and most likely there will be many more in the future.  When Manias break and Bubbles burst markets can decline over 50%.

Investors who do not have the luxury of “time as their friend” or just can't afford to have their investments lose value (even if it is temporary) will most likely need to invest in fixed income -savings and bonds. They are sacrificing potential long-term appreciation for preservation of capital.

For young investors and those who can view wealth over multiple generations, beware of low volatility investments that may result in a slow permanent loss of capital and purchasing power. And to protect against the permanent loss of capital from market crashes and downturns, invest regularly and systematically with “time as your friend.”  Losses that may at first seem permanent, may very well end up being temporary.

With a better understanding of risk, you should be able to make better informed investing decisions.