Investment risk is often defined as “the chance that the actual return from an investment may differ from what is expected”. At least that’s how most investing textbooks define it.
Check the dictionary for risk and you’ll see “the possibility of suffering harm or loss”. That’s probably closer to how most of us think about risk.
But the problem is that both definitions really miss the mark on what matters about investment risk for individuals. What we care about most is whether or not we’re going to meet our goals.
Are we going to have enough to retire on the date we planned and for the income we need? Will there be enough money to pay for our kid’s college education? When we get down to it, that’s all that really matters to us about investment risk. Will there be enough money to do what we planned?
The difficulty is that investment world doesn’t define risk this way. In the investment world, something is considered risky if its return varies greatly from the average (it’s volatile). They call it “standard deviation”. High standard deviation means risky. Low standard deviation means not risky (or not as risky). But this is the wrong way to measure risk and here’s why.
The Wrong Way
Let’s say you go to your local stock broker‘s office. You’ll probably be asked to fill out a risk tolerance questionnaire. You answer a few multiple choice questions, the broker punches it in the computer, and out pops the “perfect” portfolio for you based on your risk tolerance. The computer says you ought to invest in a 20% stock/80% bond portfolio because you have a low risk tolerance – you don’t like volatility.
But there’s a problem when you want to hand in your resignation at work just before your retirement date. You don’t have enough money! Because you used such a “safe” portfolio you never earned enough money on your investments to reach your retirement goals.
I don’t care how “safe” the portfolio is – if you can’t reach your goals by using it, then it’s RISKY! Do you really want to use a safe portfolio if it’s not going to get you to your goal? I didn’t think so.
How to Really Measure Risk
If you want to measure the investment risk of a portfolio in a way that matters, you need to look at how likely it is you’ll meet your goal with that particular portfolio. A good financial planner will help you do this by looking at the historical return and risk of the portfolio along with other information. Then they’ll use Monte Carlo simulations to estimate your chances of success.
This isn’t a perfect method and a perfect method doesn’t exist. Essentially, we’re trying to predict the future and that’s ultimately impossible. However, it’s an improvement over assuming a steady rate of return and it’s better than just a shot in the dark. The key is to revisit this estimation every few years to see if you’re on track and to adjust accordingly.
By assessing investment risk this way, you can make sure you invest in a portfolio that will provide a high enough return to meet your goals. It will help you avoid the scenario I described above because it doesn’t just look at your risk “tolerance”. It also considers your required investment return to achieve your goals.
But this method also has the additional advantage of helping you avoid taking on more risk than necessary for your situation. Look at it this way. If you can meet your goals with a medium risk portfolio allocation, then why use a high risk portfolio? You don’t need that additional risk, so you can choose to avoid it.
Now some people – especially after the most recent stock market turmoil – don’t want to increase their investment risk even if it means they won’t reach their goals. I think that’s missing the forest for the trees, but you do have some options if you don’t want to increase your investment risk. Be sure to check in later this month when I write about what to do if you don’t want that increased risk!
How do you think about risk? Are you missing the point? Am I missing the point? Let me know what you think in the comments below!