When learning about investments and investing, it’s inevitable that one of the common words you will run into is “risk.” At first glance, it may seem that risk is a pretty simple word and concept to understand. However, there are actually many nuances to this word and many misconceptions as well. In this post we will tackle the question “What is risk, really?”, as it pertains to the world of investments and investing.
So what is risk when investing? While it may seem that there should be one universal answer to this question, the answer actually depends very much on one’s specific goals and resources, because what is safe for one investor may be risky for another.
When investing, most people think of the hierarchy of risk as looking something like this:
At the high end of the risk ladder are stocks, because stocks are risky. Everyone knows that, right? A stock holder is an owner of a company, and as an owner, he or she has unlimited upside and downside potential and exposure.
In the middle of the risk ladder you have bonds, because bonds are generally less risky than stocks, but still entail some risk. As a bond holder, you are not an owner, but a lender. And as a lender you certainly incur some risk, but not nearly as much as the owner of a company (i.e. a stock holder).
Finally, at the bottom of the risk ladder is good, old-fashioned cash, because cash is basically risk free. With cash you are not an owner or a lender, and your asset is backed by the full faith and credit of the government. About as risk free as you can get, right?
This is what we are taught, and what the media reinforces every day. And for some people, this version of the risk hierarchy holds true. However, for many, the reality is that, based on their specific situation and goals, this is exactly backwards. For some, cash is the riskiest investment they can hold, bonds are less so, and stocks are the least risky of all. I realize this goes against the grain of everything we’ve been taught, but I am here today to explain why we have to rethink our preconceived notions of what risk is, and what it is not, with regard to investing.
The issue here, and the reason why my risk ladder for many investors opposes our understanding of the mainstream risk ladder, is really one of semantics. People get “risk” confused with “volatility.” Risk, as defined by Webster’s Dictionary, is simply “the possibility of loss.” According to this definition, risk has no upside potential. Volatility, on the other hand, “is the tendency to change quickly and unpredictably.” Now remember, this could be upward or downward change. And isn’t upward change, or volatility, exactly what we are looking for from our stock investments? We want stocks to be volatile. They need to be in order to grow and outpace inflation.
When we say that stocks are risky, what we really mean is that they are volatile. This is absolutely true, but it’s important to remember that for growth investors, volatility is exactly what we are looking for. On the other hand, when we say that cash is risk free, what we are really trying to say, is that cash is stable, or not volatile. I can’t argue with that, but risk-free? – certainly not.
By my definition, what risk really is, when investing, is the statistical chance of not being able to meet one’s financial goals. Risk is not the chance of seeing significant volatility; risk is the chance of failure. And for most people, this means the risk of running out of money before they run out of life. If we take this discussion one step further, in reality, the relative riskiness of stocks, as compared to bonds and/or cash, is actually different for every person. It simply depends on what you need your assets to do for you to achieve your goals. It also very much depends on whether you need to grow your assets, and the degree to which you need them to grow, or whether you need to conserve them.
For someone looking to conserve their assets, the popular hierarchy is absolutely right. Stocks are risky, bonds are in the middle, and cash has the least risk. On the other hand, for someone looking to grow their assets, the traditional hierarchy is flipped on its head. In this situation, cash is the riskiest, with bonds in the middle, and stocks become the least risky option of all.
Let’s look at two examples to help illustrate this point.
Example #1 –
Let’s say you have completed your financial plan and determined that you have plenty of money, and don’t need any growth to meet your financial goals. In other words, you can leave your money in cash and still fund your goals, such as: paying your bills, sending your kids to college, buying a vacation home, leaving a substantial inheritance, and so on. In this rare case, where there is no need for growth, then the usually-accepted hierarchy of risk is spot on. In this situation, stocks are the riskiest, because they have the highest chance of downside “volatility.” Of course, they also have the highest chance for upside volatility, but since you do not need the upside, that might not matter. If you are lucky enough to find yourself in this situation, you might as well keep all your money in cash, and forget about dealing with the stress of volatile assets such as stocks and even bonds. You have already won the game, and perhaps dealing with the potential volatility of stock is simply not worth the growth potential of your assets, since you simply don’t need that growth.
Example #2 –
Now, let’s say you have done your planning, and, like most of us, you have determined you do not have plenty of money. In this case, since you absolutely need growth to reach your financial goals, cash becomes the riskiest asset. If you don’t already have the money needed to reach your goals, and you put it all in cash, you have basically guaranteed failure. Yes, you have gotten rid of that pesky volatility, but volatility is precisely what you need, because the real risk here is not volatility, it is insufficient growth. In this scenario, stocks give you the best chances for long-term success, bonds give you less but still some chance, and cash gives you virtually no chance at all.
So, what are those people to do if they have goals they are not on track to reach, if they leave money in cash, but they don’t feel comfortable investing? The good news is there are only four simple options. The bad news is, they probably won’t like any of them, because they can either: 1) change their goals, 2) save more, 3) spend less or 4) die younger.
If you, like most people, don’t like any of these options, then you will have to be prepared to invest in stocks and bonds, deal with the volatility, and stay invested, regardless of how hard it gets when that volatility gets ramped up. That’s because for most people, no matter how hard it might be, the volatility of investing is certainly the preferable alternative to guaranteed failure. So my advice is: don’t shun volatility, embrace it.
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