What Really Matters About Investment Risk?

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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.

So you start plopping in your $300/month for retirement – everything you can afford at the moment. You go along until you hit 65, which is when you told your financial adviser you’d like to retire.

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!

Your Thoughts

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!


  1. says

    I actually think the “right” way is probably in the middle – if I am putting $350 and making myself sick watching it go up and down because it is a volitile portfolio I doubt that would be a good option.

  2. says

    Evan, I see your point, but if you invest in a way that doesn’t meet your goals (i.e., you can’t retire as/when you wanted) then can it still qualify as the “right” way? I just think we need to be careful about mixing emotions and investing.

  3. Alan Reed says

    I think emotions are part of investing. If you can’t sleep at night I don’t think you are meeting or acknowledging a complete set of goals. As with everything, balance is the key to success. There are many considerations that go into risk. I think the key elements are: time, knowledge, diversity and a good feeling about the plan. My final point is to emphasize knowledge; after all it is your money.

  4. says

    Alan, I agree that balance is the key. That’s what I’m getting at if you follow the conclusion – there are alternatives if you don’t want to increase your risk. So if you can’t sleep at night because your goals require you to use a riskier portfolio than you’re comfortable with then you’ll need to adjust your goals downward so you don’t need as much risk.

    Craig, I saw a comment come in my email earlier from Kevin at Christian Simplicity. Do you know what happened to it? I wanted to respond but your site was down then.

  5. says

    I think this is a very good point. We are taught that “risk = volatility”, and so we seek out investments that are more predictable if someone is risk adverse. I hate to see someone just blindly follow a few indicators (age, risk tolerance quiz, etc) and force someone into an investment that has a high risk of having them not meet their goal.

    I think if the person can’t sleep at night with the plan that allows them to meet their goals, they will have to change their goals, or change other inputs!

  6. says

    Exactly, Khaleef! There’s more to choosing a portfolio than just looking at your risk tolerance. It’s foolish to ignore the other factors like the portfolios ability to help you meet your goals. As you said, if you’re not comfortable with the required risk then you’ll have to change something. My next post will deal with this balance and some of the factors you can adjust to let you use a lower risk portfolio.

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