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.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
Great post. I think you are completely right. I actually see no risk in investing, why? With each paycheck money is whisked away to "investing land" where it becomes nothing but a number. My investing is like a game to see how big I can get that number before I quit working. My life is great without the money, I don't miss it. If my investment decline it does not affect me at all, I just try harder to win the game (aka save more and maintain my asset allocation). If I never had the money to begin with how can I miss it? How is it risky if it is money I don't need (at least until retirement decades away).
Very much enjoyed this post - a refreshing way to look at the importance of investing. You often hear about the other side of "risk" and this is just as (more?) important a point of view. Thanks!
You're right, that wasn't the best analogy I used. Selling for a loss on an investment purchased with the intent of appreciating over 20 or 30 years is simply realizing a loss. If the investment is volatile by nature, selling early may simply force you to realize a loss based on being afraid of volatility in terms of risk, when it in fact may simply be the nature of the beast.
But hey, this is why there are comments on a site like this. Everyone can benefit from the different viewpoints and expansion on topics.
Jeremy, I'm not disagreeing with what you're saying here. My original disagreement was with the statement, "you only take a risk when you sell for a loss". That is realizing a position, not assuming risk. That's all.
I understand fully and agree with you that the "risk" is very low for a 30 year old with a long time horizon who invests in well diversified things. These are risk mitigation efforts because their is still a chance for loss, albeit an off one.
I do appreciate the opportunity for the discussion though. Many would just fly off the handle the moment someone shows a counter viewpoint.
Fiscal Musings, no, I agree with you that the words aren't interchangeable, and that is the underlying point I was trying to make with this post. It is just that when someone says they are risk adverse, or don't want to have risky investments, what they are really worried about is volatility. Meaning, they don't want to see their account values go down, or at least not down significantly.
So, going back to Investopedia's definition: "The chance that an investment’s actual return will be different than expected."
This is where it all comes down to what is expected. If a 30 year old has a 100% stock portfolio that is designed to be for retirement savings 30+ years from now, with the way the word risk is thrown around, this appears to be a risky portfolio. Does 100% stock have a high standard deviation? Yes, but that really just measures volatility, not overall risk.
History has shown that stocks typically return between 9-11% annually. So if this 30 year old investing in stocks for the next 30 years, what is his EXPECTED result? He probably expects that 30 years from now that he will have realized close to that return, and if history is any indication, that is far more likely than unlikely, thus low risk.
If you just think of risk as standard deviation, you could argue that an FDIC insured savings account carries no risk, but that is false. While the risk of losing your principal is 0, you are faced with interest rate risk, inflation risk, and the risk of outliving your money.
Which brings me to the original point of this post, is that if a person like this is trying to save for 30 years for retirement in an account that has no apparent risk (i.e. their account value can't fluctuate or go down in value), they will be taking on far more risk that after inflation, taxes, and the length of their life that they will be unlikely to fulfill their goals or have enough money to sustain their full retirement.
Thank you thank you thank you.
I've been saying this for years.
I wish I could have shown this post to my Corporate Finance professor in graduate school.
I can see what you're getting at, but it doesn't make any sense to "realize a risk". When you sell at a loss, you've realized a loss, and it ceases to be any sort of risk because there's nothing uncertain and no chance involved anymore.
And when you talk about long time horizons and diversified funds, you have to call these tactics what they are: ways to reduce or hedge the risk of investing in the market. If risk and volatility were interchangeable, we wouldn't have the distinction of the two terms.
Well nothing completely eliminates risk, but when you sell a position for a loss, you have cemented your loss, or otherwise realized the very risk that you were afraid of. Just like a stock or investment can go down in value, it can also go back up in value. So if you sell, you "realize" the risk, when in fact, for all you know, the investment could return to or increase in value, making that supposed risk non-existent.
And again, this type of discussion is for someone who has a non-diversified portfolio and is invested in a single company, or a single sector like airlines. In almost any real world scenario, the collection of funds and investments someone holds makes up hundreds, if not thousands of companies. This makes the typical definition of risk almost worthless if you are talking about a time frame of decades.
For most investors who invest in index or mutual funds, ETFs, or other diversified methods, even a 100% stock portfolio wouldn't be very risky. Volatile from day to day and year to year? Sure, but if you just owned an S&P 500 fund for 25 years, what is the probability of losing money over that time frame? I'd have to say it would be pretty close to 0.
So my only argument with this is to highlight the fact that when most people are talking about risk, they are really concerned with volatility. And by making unwise investment decisions by trying to minimize a risk that isn't as real as it seems, they are putting more important long-term risks in danger.
Unfortunately, I must disagree with you. "You only take a risk when you sell for a loss"...? The meaning of the word risk presupposes an undetermined outcome. If you sell for a loss, you know what the outcome is and therefore are actually under less risk because the investment can't go down any further.
While the tactic you mention of not selling may be one way to reduce or hedge your risk, it does not get rid of your risk. Just look at the auto or airline industry (many billion dollar companies).
I would look at how Investopedia defines risk:
The chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. Risk is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.
That's exactly right, and that is the risk of outliving your money. If you just tuck it away in a savings account, CDs, or other investments that can barely keep up with inflation, you'll find that in 20 years and paying taxes on the money, you've actually lost money.
Sure, most people think that because the dollar amount is bigger than what they started with that they made out pretty well, but all they've done is waste their working years only to find out they won't be able to afford any of the things they had planned for the non-working years.
Great article, fully agree. There is something else to add - when consider the risk of losing when investing in stocks (or whatever else), people forget to consider the risk of the money losing its value if they don't invest at all.