Defining Risk Part 2

For part 1 see Defining Risk

Just over a month ago I wrote on the subject of risk with an attempt to define what risk really is (at least for me). I ended the article by defining that risk was anything that stood in the way of accomplishing an objective. A recent correspondence with a reader made me rethink how my definition was presented. The subject of risk is often discussed in a negative or derisive manner. It is something we seek to avoid or banish from our lives. My definition clearly falls into this category. However, there may be another side to risk that I failed to see in my previous post. Consider the following definition of risk from Apple Computer’s former CFO Peter Oppenheimer

The degree to which an outcome varies from expectation. [1]

Oppenheimer makes reference to expectation instead of an objective or goal–a more expansive way of thinking about the outcome. Expectation implies there is a belief about what should happen while acknowledging that there is a range of possible outcomes. It inherently places a certain level of responsibility on the practitioner to acquire knowledge regarding what could happen. While we don’t have control of the outcome, we do have control of our expectations. In that sense Oppenheimer’s definition may be viewed as empowering.

Apparently Oppenheimer isn’t the only one to use expectations as a proxy for risk. Last year John Rekenthaler of Morningstar wrote on investor expectations as it relates to fund returns

Relative predictability–a phrase that Bogle mentioned in passing to me, in a conversation last week–is something altogether different. The relatively predictable asset is the asset that behaves as expected, given the performance of the financial markets. Relative predictability has nothing to do with the usual statistics that measure absolute levels of risk. It cannot be measured by standard deviation. Relative predictability is unrelated to volatility.

He continues

Tracking error, which measures how far a fund’s performance deviates from that of its benchmark, assesses one aspect of relative predictability. But there’s much more to the concept than that. Critically, realized tracking error does not incorporate expectations–the beliefs and hopes that investors place in their funds. [2]

The “beliefs and hopes that investors place in their funds” may be interpreted in different ways. To use myself as an example I have owned the Vanguard Small-Cap Value Fund in my 401(k) for several years. It’s volatile, to say the least, but that’s exactly what I expect. Some might view that holding as risky, but from my perspective I’m simply getting what I paid for–a volatile asset with higher expected returns.

Another big idea that Rekenthaler mentioned and I believe is integrated in Oppenheimer’s definition is the concept of relativity. It’s not stated specifically, but there exists the idea that an outcome can vary from the expectation in both a negative and positive manner. In other words, outcomes can fall short of expectations, but it’s important to realize that they can also exceed expectations. In that sense the definition also pushes us to think through the full range of possibilities, and ponder the consequences both good and bad. As I said before risk typically focuses on negative outcomes, but is it possible that something perceived as good could also represent risk?

Here are some thoughts:

  • High quality fixed income instruments almost always guarantee a return of principal plus interest, but the resulting low returns can be incredibly risky to someone who is looking to grow their purchasing power.
  • Taking on too many clients too quickly places a business in the risky position of not being able to serve existing clients fully or in the best way possible.
  • Eating too much junk food can pose a risk to your waistline, and your long term health.
  • Achieving financial success and obtaining too much “stuff” (boats, cars, houses, etc.), only to have these possessions demand more time, money and resources. Instead of the purchasers owning the things, the things end up owning the purchasers.

Business and personal considerations aside there are some broader societal and economic aspects that also fit the mold of “too much of a good thing.” While we applaud people for their ability live frugally and save (especially these days), too much aggregate savings can actually harm an economy. Ray Dalio’s Economic Machine explains that one person’s spending is another person’s income. Therefore, as savings in an economy collectively increases aggregate spending must decrease. Less spending means less revenue for businesses, which are then forced to reduce costs and layoff workers. Consequently income, in aggregate, will also decrease and prohibit further saving. The “paradox of thrift” as this concept is more popularly known was captured by economist John Maynard Keynes in his work The General Theory of Employment, Interest, and Money

For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself. It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment. [3]

Another example of excess creating risk would be a strong bull market, which is best captured in the mantra of value investors. In this context assets are viewed to be least risky following a crash (when they’re cheap) and most risky after a string of strong positive returns (when they’re expensive). In the words of Howard Marks

Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as their psychology strengthens and they become bolder and less worried, investors cease to demand adequate risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it. [4]

These are just a few examples and I don’t doubt that there are many more. If you’re looking for a really good read on excess in our current economy I would check out Josh Brown’s Abundance. It could not have been better written, and really makes you stop and think about the current state of affairs.

A small personal note, I’d like to thank Mike Carpenter of Carpenter Associates for his insight and suggestions that helped inspire this post. Mike has a more thorough examination of Oppenheimer’s definition of risk in his book The Risk-Wise Investor. Thanks Mike!

1. Carpenter, Michael T. The Risk-Wise Investor. John Wiley & Sons, Inc. Hoboken, NJ. 2009. pp. 42-43.
2. Rekenthaler, John. Jack Bogle’s Great Insight. Morningstar. June 11, 2015.,;frmtId=12,%20brf295
3. Keynes, John Maynard. The General Theory of Employment, Interest, and Money. Prometheus Books. Amherst, NY. 1997. p. 84.
4. Marks, Howard. The Most Important Thing. Columbia University Press. 2013. p. 68.

NOTES – The Risk-Wise Investor.pdf

What I’m Reading
Index Investing Makes Markets and Economies More Efficient (Philosophical Economics)
How Much Are Those Dividends Costing You? (Meb Faber)
The Gospel according to Buffett (Robin Powell)