In the world of finance and investments, the discussion surrounding risk is everywhere. Stocks carry risk, borrowing money has risk, you risk losing your job or becoming disabled–risk is everywhere. But what does risk really mean? To find out, I spent the last week asking people that very question. These are regular people, most of which have no background in finance aside from tucking away some money for retirement.
So, what is risk? Overwhelmingly, it came down to losing money. For over 90% of the people I asked, they quickly answered that risk meant loss of money. But what does a loss really mean? Is the fact that your account balance is lower today than it was yesterday a loss? Is it the fear of losing everything? Or is it just the fear of uncertainty, knowing that your money will be growing irregularly? When it comes to risk, none of these things define risk, yet they are what most people use to measure risk.
The Two Most Important Types of Risk
If you want to really define risk, there are two primary types of risk that we all face:
- The risk you will outlive your financial resources.
- The risk you are unable to accomplish your most important goals during your lifetime.
Since both of these types of risk are for the most part directly tied to money, it is easy trick yourself into thinking that the possibility of having a bad day in the market equates risk. Clearly, if you don’t have enough money, you run the risk of outliving it. Just the same, if you don’t have enough money, you may not be able to accomplish some of your lifelong goals.
Investing Money in the Stock Market is Not as Risky as it Seems
Let’s break down this sense of “risk” that most people have in terms of the possibility of losing money. For a worst-case scenario, let’s assume you choose the riskiest investment for most people–an individual stock. As many people would tell you, that is a risky move because your potential for loss is significant, but is it? Well, the potential of losing your entire investment is actually relatively slim. If the stock you pick is a large company that has been around for a hundred years and worth billions of dollars, do you think there is a high probability of it going bankrupt so that you lose every penny you invested? Probably not. That’s not to say it can’t happen, but even in this situation, it isn’t extremely likely either.
So really, we aren’t talking about risk as much as we are volatility, which just means that the value of your investment is going to have fluctuations. If you buy today for $50 a share and sell tomorrow for $40 a share, yes, you have lost money. But if you buy today for $50 a share and tomorrow it is $40 a share, but you don’t sell, have you lost money? No. What happens if it comes back to $50 the day after, or even higher? This is volatility, not risk. You only take a risk when you sell for a loss.
Now that we’ve examined the scenario that is considered the most risky by most people, let’s look at a more realistic example. Since you aren’t going to bet your entire future on a single stock, you’re probably like most people and own a few mutual or index funds. Even if you only own two or three funds, you probably hold 500 individual companies. Thinking about risk in terms of losing money, what are the chances that all, half, or even 10% of those companies go bankrupt? Extremely slim to none. Even so, you can see a decline in value during certain periods, but the chance of actually losing your investment is quite small unless you’re forced to sell at a loss. Again, during short time periods, when you appear to be losing money, it is simply volatility, or price fluctuations.
The Potential for Loss is Far Outweighed by The Possibility of Unfulfilled Dreams
Losing money is devastating. Nobody wants to get their quarterly statement and see a negative number, and that is understandable. We spend years planning on how to save and invest this money so that we can use it to fulfill our desires, so when we see that we suddenly have less of it, it stirs up emotions and fear. This worry is more often than not, quite unnecessary. Unless you are depending on 100% of that money you have saved up to do something tomorrow, chances are you shouldn’t be too concerned.
For the average person, the probability of outliving their money so that they can maintain the lifestyle they want is very high. Even with Social Security, and in unlikely cases, a full pension, most people will only be receiving between 40-60% of the income they actually need. The remainder of the income needs to come from personal savings. With inflation, rising health care costs, and the fact that people are living longer than ever, the odds are stacked against you. You have a significantly higher chance of running out of money and being required to decrease your lifestyle than the chance of losing most of your investment money.
Even more devastating is when you come to the realization that you are unable to accomplish the things in life that you have set out to do. Whatever your goals and dreams are, failing to reach them is disheartening. Unfortunately, this is a very real possibility when you fear risk and try to maintain a sense of security during your working years. It may feel good to know that your quarterly statements never have a negative number, but for that piece of mind, you’re likely going to be faced with some unpleasant decisions in your later years.
It is time to begin thinking of risk differently. It isn’t about the fact that your investment accounts go up and down over short periods of time, but the real risk lies in the possibility of being unable to fulfill your dreams and reach your goals. You can significantly reduce the fluctuations in your account by buying seemingly safe investments, but in doing so, you’re just increasing the risk that you will leave some desires undone later in life. Ask yourself what is more important–little or no volatility in your long-term investments, or financial independence.
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About the Author: Jeremy Vohwinkle is a Chartered Retirement Planning Counselor® and spent a few years working as a financial planner. Today, he helps people make the most of their money by writing about personal finance here and elsewhere on the web. Jeremy is also Coach at Adaptu and a regular contributor for other publications such as Intuit, and American Express. Be sure to follow Jeremy on Twitter or Google+.