Understanding Risk
"Playing safe is very risky."
-Seth Godin
It's June 2010 in Las Vegas. It's 6:30 am. I'm taking a bus to Tropicana, where I'm getting picked up to go skydiving. I was out too late last night because I met up with some people from a rafting trip that finished the day before. When I get to Tropicana I meet a fellow first-time skydiver from Costa Rica. We talk a little bit and then are given waivers to read through and then sign. As I start reading my waiver I see my new friend initialing every page without reading it. I asked about it and he replied, "I want to skydive but they don't let you go unless you sign; I don't want to know what it says."
Risk = Something Can Go Wrong
At its core risk simply means something might go wrong. Period. You might slip on the ice getting your mail. You might get into a car crash on the way home from work. You might get injured going for a run. Your house might burn down. All of these examples are things that could potentially happen. There is a chance. That chance is called risk.
Viewing risk as the chance that something might happen implies we can think about all the things that might happen and assign probabilities to them (that just means we know what the odds are). Some people will say that you can assign probabilities to risk, but uncertainty is something you had no idea was going to happen. Author Carl Richards defines risk as what's left over when you think you've thought of everything. That's kind of like how many use the work uncertainty.
The bottom line is that you have an ideal path you'd like your life to follow, and the chance that something (whether you know about the risk or not) could happen to ruin your ideal path is called risk.
There are Two Dimensions to Risk
Thinking about risk should be thought of in two ways. First, how likely is it that something bad will happen? Second, if something bad happens, how bad will it be?
Likelihood: We all face the risk of getting heart disease. But it is more likely to happen to someone who eats less healthy foods and doesn't exercise as much. The consequences are the same in both cases, but it's more likely to happen to the less healthy person.
Similarly, if you have your money invested in the stock market, there is a risk that you'll have to sell your investments after a loss. That is the consequence. However, people who have a plan in place to keep money they need out of the stock markets and understand market history are less likely to have this risk show up.
Consequence: Sometimes two situations are equally likely. Magician Penn Jillette, of Penn and Teller, explained one of their tricks by saying walking a tightrope between two trees a foot off the ground is the same stunt as walking a tightrope between two skyscrapers. The probability of falling of the wire is the same (or close enough to the same). The difference is the consequences of falling from a foot off the ground are far different from falling from the top of a skyscraper.
In investing, the chances of losing money in your friend's startup are the same, but the consequences are different if you invest a tiny portion of your net worth versus your entire life savings.
Risks in Investing
Many people have only a foggy idea what risk means when it comes to investing. Many envision the risk of losing money, but it's not entirely clear what they mean by that since, unless you sell after a drop, markets have always recovered. So what does risk mean when it comes to investing?
Of course, there is not just one definition or type of risk. Let's take a look at a few of them.
Market Risk: This is the closest to what most people think about when they think about the risks of investing. Sometimes this gets estimated with a statistical term called standard deviation, which just talks about how much the data vary around the average. If the average height of a population is 5'10", and everyone is between 5'9" and 5'11, the standard deviation is low. But, if everyone is between 4'10 and 6'10, then the standard deviation is high. With investing, the return (like an interest rate for investments) that people expect is like the average and if the actual returns will be close to that average, they call it low risk. If the outcomes are all over the board, that's called high risk.
I don't much like this definition. For starters, nobody cares if the return is higher than the average. Secondly, remember that there's never been a time that investments haven't recovered (I'm talking about diversified investments here...there have been many cases of single companies going to $0). So I'm going to take a stab at a better definition.
Market Risk (Derek's Definition): The chance that you have to sell your investments after the investments have dropped in value, either because you need the money for a known reason or because you have become too nervous and can't take it anymore. Either way, market risk is that chance that we lock in losses.
Inflation Risk: Inflation is the risk that we don't make enough of a return to combat inflation. If inflation is 3% (that is, the cost of the stuff we buy goes up by 3%), but we make 2%, we lose. It sounds silly, but in times of high inflation, people are ecstatic to make 20% when inflation is running at 25%. Similarly, in times of low interest rates, people are devastated when they make 3% but inflation is at 1%. The risk of inflation is what I call the opposite of the risk of the markets. If you don't want to take market risk, then you have (inadvertently) subjected yourself to inflation risk.
Concentration Risk: Concentration risk is the risk that too much of your money is tied up in too few investments. Earlier I mentioned that there has been no time a diversified group of investments has not recovered, but single companies have. Having a majority of your money in a single company is an example of concentration risk.
Those are the biggies. If you have the time and interest, feel free to Google tracking risk, manager risk, counterparty risk, interest rate risk, liquidity risk, credit risk, currency risk, reinvestment risk, or horizon risk. This is meant to show you that there are many, many different ways to define risk in the world of investments.
Insurance
There are other risks that don't involve your investments, such as your house burning down, breaking a bone and suffering large medical bills, getting sued for damaging someone's property in your car, dying too early (and leaving your family without your income), and living too long (and running out of money). These are the kinds of risk that have a very low chance of happening to you, but if it does, it can ruin you because the costs are so high. It's with these kinds of risk that people buy insurance to cover. In essence, an insurance policy is a contract where you pay someone to take on that risk so you don't have to. You pay premiums to an insurance company and if that bad event happens, they'll cover the cost.
Risk and Reward Are Related
Remember when I said risk means the chance that something bad will happen. Let me further say that having the value of your investments go down is not risk! That is a guarantee. Investments go up, and they go down. The risk is not that the value of the investments will go down; the risk is that you sell the investments when they are down. The more they fluctuate over time, the higher you can expect to make, because it's hard to deal with these fluctuations. You are compensated for dealing with this in the form of higher long term returns.
It doesn't have to apply to just investments. For some, skydiving is an event that comes with risks, including the risk of death. By taking on these risks, we are rewarded with adventure, adrenaline, thrills, and the ability to brag to your friends.
Leaving your house comes with the risk of getting hit by a car or falling debris from an airplane, or attacked by a wild animal (I didn't say they were probable, just possible). But by ignoring that risk you don't get to leave your house to work, play, or visit friends and family.
If risk and return were not linked, then nobody would take risks. If there were no market fluctuations, we wouldn't make more by investing in stocks. We have to take risks in order to get something in return.
Choosing Our Risks
Remember that you can avoid the risk of getting mauled by a wild animal by never leaving your house. However, that comes with its own risk. You risk a higher chance of dementia since you will have fewer human interactions. You face health risks because you're not going outside to exercise, or get fresh air. Not investing in the stock markets introduces you to inflation risk.
It's not a matter of choosing to be risky or not. It's a matter of choosing which risks we are comfortable accepting. We get to choose the risks, and subsequent rewards, that we can tolerate and that we find worth it. Not taking any risk is boring...and simply not possible. But, understanding the risks you face and managing them is not only possible, it's good money health.
Read Next:
References:
Carl Richards: The Behavior Gap
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