What is Risk?

In Short

Risk is the possibility that at a particular moment in time, you won’t have enough money to pay for whatever you need to pay for.

Fluctuation is Noise

The market fluctuates up and down like a roller coaster. The magnitude of the fluctuation is called risk. Most of these movements mean nothing. They are statistical noise. Think of a drunk standing at a light pole and staggering about. This graphic example is the random walk theory. Short term movements are noise.

Over Time Fluctuation Vanishes

Now step back a bit and look at the movements over a month. The little gyrations are gone. There is still a lot of random jerking about, however. A bad or good return for a month, does not mean much but means more than it does for a day. A year means more than a month. Ten years means more than a year and so on.

Risk Vs. Reward

In general, the more risk (the more fluctuations) you endure, the higher the long term return of your portfolio will be. However, in the short term that portfolio might be down. It could be in continuous freefall for 2 years or more. The portfolio will probably go up in value over the long term (20 years) but that doesn’t help you in the short term. If you need that money to pay for something now then you’re in trouble. My 92 year old mother takes very little risk in the stock market because she doesn’t have the time to wait out a market collapse. If her portfolio drops 50% in a market meltdown, she doesn’t have 20 years for the portfolio to make up for that lost ground and to surge higher. She needs that money now.  Risk depends on your point in life. For example, somebody who is still working can recover from an investment disaster better than a retired person. They have more years in front of them. Risk also depends on emotional tolerance. I know young people who emotionally can’t handle any risk and old people who want maximum risk.

Types of Risk

There are two basic kinds of risk. Individual stock risk are the weird good or bad things that happen to one company. A new product, a lawsuit, the Tesla autopilot malfunctioning, a cure for cancer from a drug company, etc. are examples. They cannot be profitably predicted. Remember all information is known and already reflected in the stock price. Market risk is the whole market going up and down. A mutual fund holds many stocks. Therefore, the individual stock risk is blended out. The weird good and the weird bad cancel. That’s a good thing. Even if a company is making a lot of money and is growing well, there is always the chance that a freak storm is going to destroy the factory and drive the company to bankruptcy. There is no way of predicting that; there is no reason to take that risk. Mutual funds do not cancel market risk. I use an allocation towards short term bonds together with rebalancing to reduce market risk.

As I’m writing these to help my readers, I would be very appreciative of any input in regards to what I should write next. If you want me to write about a particular topic, please contact me. If you would like to submit a post to my blog, please contact me.

If anything that I mentioned above interests you, please consider downloading my free e-book. The book contains my thoughts on investment management and some information that I think everyone should know. You can also download it below.

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Questions for the comments

Did my explanation make sense? Do you agree or disagree with what I said?

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