A better definition of investor risk?
When one of your clients thinks about investment risk, do they see this equation in their head? Do you?
This is the equation for standard deviation of returns, which is the cornerstone of most discussions about investment risk. It’s a statistical measure of the volatility of a portfolio or security.1
When we use the word risk, it’s usually shorthand for the possibility of losing money. This definition is at the heart of the risk versus reward discussion. Equities are deemed riskier than bonds because they’re more volatile, although they hopefully have the potential to earn more on average over time.
A risk tolerance questionnaire asks questions designed to uncover an investor’s feelings about volatility. How much sharp market movement might your client endure before she flees? Answers to tolerance-related questions like this will help identify her risk profile and point to a suitable portfolio asset allocation on a continuum of conservative to aggressive.
But what happens when the money in a portfolio needs to fund her retirement spending? Volatility becomes secondary to the real risk this investor faces: the risk of running out of money before she runs out of life.
This plain speech definition of risk is more meaningful to the problems facing most investors. In fact, it’s a definition we should apply to any elaborate abstraction about investing. Doing this regularly can keep you grounded and help you better connect with your clients.
This does not mean volatility is unimportant. Emotional reactions to market losses are real, and can derail even the soundest long-term plan. But low volatility, while desirable in isolation, does not fund goals. Investors need to balance it against the likelihood of actually meeting these goals.
In future posts, I’ll detail ways we at Russell look at more meaningful aspects of risk.
1 Standard Deviation is a statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution. The greater the degree of dispersion, the greater the risk.
Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets.
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Series: Meaningful aspects of risk