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Investment risk: what is it and how a two-headed hyrdra monster can ruin your investment returns

Been talking to a lot of investing people about Risk recently: what it is, how to measure it, how to control it.

Why Risk matters

Risk is one of those things you don’t realize you have too much of until it’s too late. Being able to manage risk effectively is essential in the investment process.  Get it right and you hit your goals. Get it wrong and the potential for catastrophic losses is immense.

I don’t agree with the buy-and-holders who believe holding forever erases risk. Risk is always there, lurking around the corner.

There are huge issues and ones that many academics and entrepreneurs are beginning to tackle in meaningful ways. Imagine if we can get to a point where we can personalize risk — with financial advisors and with DIY investing tools.

What is Risk

From the literature I’ve been reading, Risk is one of those terms whose meaning few agree on. And like many Eastern concepts, it’s frequently an evolving concept, defying being captured by a single definition.

In fact, Risk may best be described (not defined) by what it’s not.

I happen to like what Zvi Bodie in Risk Less and Prosper: Your Guide to Safer Investing does with Risk:

Let’s discard the idea that risk is nothing but the unknown, because risk is more than the ordinary uncertainty that surrounds our lives. By referring to harm, loss, and fear, the next three suggestions reflect one fundamental property of risk: Somebody has to care about the consequences if uncertainty is to be as risk.

The notion of “caring” or “mattering” is central. It captures both the potential (objective) impact of uncertainty as well as its (subjective) bite. This brings us close to the definition we’ll adopt: Investment risk is uncertainty that matters. There are two prongs to this definition—the uncertainty, and what matters about it—and both are significant.

So, beyond the odds of hitting a rough patch, there are the consequences of loss to consider. What will happen if you miss your goals? If you look to your goals as benchmarks for measuring risk, you’ll deepen your appreciation of what goals make sense for you.

Investment risk is two-headed Hydra beast thing

There are two sides of risk:

  1. uncertainty: one is our inability to accurately forecast the future. That uncertainty means as investors, we have to use specific tools to avoid or soften the blow of the unforeseen.
  2. personal impact of getting it wrong; If you get investing a little wrong, no worries. But screw up planning for you retirement on the eve of the next stage of your life, and well, you’ve got a big problem. My Dad likes to joke, “I’ll just work until I die…”

Investment risk had been glossed over in the past. It’s easy to look like you’re performing well when the market just goes up and up. Long-term though, it’s really your risk-adjusted returns that matter.

That’s something the advisory world hasn’t paid enough attention to and something individual investors haven’t even had the language or tools to address.

That’s changing.

Life = Risk


Photo by kyz

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    [...] risk is always out there.  Because risk is all about how we personalize and internalize it, our behavior changes the more we become aware of it. Like a water snake, its slippery nature [...]

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  • http://twitter.com/finsovet finsovet

    Probably the best definition of risk ever.

  • http://www.tradestreaming.com Tradestreaming

    wow, thanks!

  • http://www.tradestreaming.com/2012/02/14/3-things-investors-can-learn-about-risk-from-the-u-s-army/ 3 things the Army can teach investors about risk | Tradestreaming

    [...] The U.S. Army separates the definition of risk from uncertainty (like we did in last week’s post on defining investment risk). [...]

About Tradestreaming

Tradestreaming is a community of investors learning directly from experts. I’m Zack Miller, investor, entrepreneur, and founder of Tradestreaming.com and I literally wrote the book on how to invest in the age of Facebook and Twitter. Tradestreaming is the resource I’ve created to help me become a better investor.  I believe it will help you … Continue Reading