What is risk?

The search for an answer to this question has puzzled philosophers, mathematicians and thinkers for centuries. The question seems so simple but attempting to answer it proves to be quite challenging. The various definitions of risk floating around are fairly broad–so broad that Peter Bernstein wrote an entire book on the subject.

Many academic models–such as mean-variance optimization and the Capital Asset Pricing Model–use standard deviation or it’s close cousin, Beta, to define risk. Quantities such as these are actually indicators of volatility, or how much the returns of a security fluctuate up and down. Is volatility synonymous with risk? Maybe. Using a number to define risk works tremendously well for mathematical modeling, but fails miserably when it comes to other aspects of investment planning and practice. Consider what the oracle had to say

The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability — the reasoned probability — of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. [1]

James Montier of GMO offers a much more straightforward definition. Risk is the permanent loss of capital. [2] While somewhat different from Buffett’s definition the two actually have a lot in common. Say you purchased a stock only to see it immediately decline in value. Spooked by this behavior you sell and take a loss. You not only suffered a permanent loss of capital, but lost purchasing power as well. In this instance the definitions are the same.

Buffett’s definition differs in that he acknowledges the concept of purchasing power, or return in excess of inflation. Instead of stock let’s say you purchased a 20 year Treasury Bond and held it to maturity. At maturity you receive full principal and suffer no loss of capital. However, history has shown that Treasury Bonds produce returns only mildly higher than inflation (at least compared to stocks). As a result you are unlikely to increase your purchasing power by a substantial amount. Inflation presents a very dangerous form of risk as it is hidden in broad daylight. It’s there, but ticks along slowly at about three percent per year. We seldom notice it’s effect in our day-to-day lives.

For most individuals risk has a far more basic meaning. A simple way to demonstrate some of the risks faced by individual investors is to revisit the formula for compound interest. The formula shows three components that determine the future value of an investment: the amount of money an investor starts with (Present Value), the rate of return (r), and the amount of time the investment is held (n). Each of these components brings a form a risk with it.

Future Value = Present Value*(1+r)ⁿ

Present Value: Present value is simply the amount of money that we start with. One of the simplest ways to risk future value is by not saving enough. As the old adage goes “it takes money to make money.”
Time, n: Time is the great equalizer. Every single person on the planet has the same 24 hours in any given day. From a financial perspective we should ideally be using as much of that time as possible to allow our investments to compound. When we delay saving and investing we take a risk by reducing that compounding time. Put this off for too long and you’ll either have to save a lot more money or worse–you may not be able to retire. Period. But there’s a silver lining to time. Those who do start early can save and invest less money and still achieve their goals.
Rate of Return, r: Everybody wants a higher rate of return, myself included. Unfortunately few if any can earn more than the return of the market. We should also be aware of the impact that inflation has on our returns. Improving purchasing power is a very important part of investment planning, and for most people this is easily achieved by owning stocks.

The thing to keep in mind is that risk is very contextual. Everybody comes from a different background or is currently working through a different situation. What’s risky for one person may not be risky for another. Perhaps trying to define risk is the wrong pursuit. Instead we should be defining our goals. Risk is simply anything that gets in the way of accomplishing our objective(s). Volatility. Inflation. Loss of capital. Not saving enough. These and many other things could easily be hurdles to overcome and all could fall under the definition of risk.

References
1. Buffett, Warren. Warren Buffett: Why stocks beat gold and bonds. Fortune. February 9, 2012. http://fortune.com/2012/02/09/warren-buffett-why-stocks-beat-gold-and-bonds/.
2. Montier, James. The Seven Immutable Laws of Investing. GMO Whitepaper. March 2011. http://ftalphaville.ft.com/files/2011/03/JM_SevenImmutableLaws_312.pdf.

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What I’m Reading
Why Bigger Really Is Better For ETFs (Allan Roth)
Alternatives to Being an Evidence-Based Financial Advisor (Robert Seawright)
How Life Insurance Loans Really Work And Why It’s Problematic To “Bank On Yourself” (Michael Kitces)