What Is Risk?
Given how fundamental risk is to
investments, many new investors assume that it is a well-defined and
quantifiable idea. Unfortunately, it is not. Bizarre as it may sound,
there is still no real agreement on what "risk" means or how it should
be measured.
Academics have often tried to use volatility as a proxy for risk. To a certain extent, this makes perfect sense. Volatility is a measure of how much a given number can vary over time
and the wider the range of possibilities, the more likely some of those
possibilities will be bad. Better yet, volatility is relatively easy to
measure.
Unfortunately, volatility is flawed as a measure of risk. While it is true that a more volatile stock or bond
exposes the owner to a wider range of possible outcomes, it doesn't
necessarily impact the likelihood of those outcomes. In many respects,
volatility is more like the turbulence a passenger experiences on an
airplane – unpleasant, perhaps, but not really bearing much relationship
to the likelihood of a crash.
A better way to think of risk is as the possibility or probability of an asset
experiencing a permanent loss of value or below-expectation
performance. If an investor buys an asset expecting a 10% return, the
likelihood that the return will be below 10% is the risk of that
investment. What this also means is that underperformance relative to an index
is not necessarily risk - if an investor buys an asset with the
expectation that it will return 7% and it returns 8%, the fact that the S&P 500 returned 10% is largely irrelevant.
What Is a Low or High-Risk Investment?
If investors accept the notion that investment risk is defined by a loss of capital and/or underperformance relative to expectations, it makes defining low risk and high-risk investments substantially easier.
A high-risk investment is one where there is either a large
percentage chance of loss of capital or underperformance, or a
relatively small chance of a devastating loss. The first of these is
intuitive, if subjective - if you were told there's a 50/50 chance that
your investment will earn your expected return,
you may find that quite risky. If you were told that there is a 95%
chance that the investment will not earn your expected return, almost
everybody will agree that that is risky.
The second half, though, is the one that many investors neglect to
consider. To illustrate it, take for example car and airplane crashes.
The odds of any driver experiencing a car crash in their lifetime is
quite high (25%), but the odds of death are relatively low (less than
1%). By comparison, the odds of experiencing a plane crash are quite low
(one-hundredth of 1%), but the odds of dying in a plane crash are quite
high (about 67%).
What this means for investors is that they must consider both the
likelihood and the magnitude of bad outcomes. Low-risk investing not
only means protecting against the chance of any loss, but it also means
making sure that none of the potential losses will be devastating.
Low Vs. High-Risk Investments For Beginners | Investopedia
Given how fundamental risk is to
investments, many new investors assume that it is a well-defined and
quantifiable idea. Unfortunately, it is not. Bizarre as it may sound,
there is still no real agreement on what "risk" means or how it should
be measured.
Academics have often tried to use volatility as a proxy for risk. To a certain extent, this makes perfect sense. Volatility is a measure of how much a given number can vary over time
and the wider the range of possibilities, the more likely some of those
possibilities will be bad. Better yet, volatility is relatively easy to
measure.
Unfortunately, volatility is flawed as a measure of risk. While it is true that a more volatile stock or bond
exposes the owner to a wider range of possible outcomes, it doesn't
necessarily impact the likelihood of those outcomes. In many respects,
volatility is more like the turbulence a passenger experiences on an
airplane – unpleasant, perhaps, but not really bearing much relationship
to the likelihood of a crash.
A better way to think of risk is as the possibility or probability of an asset
experiencing a permanent loss of value or below-expectation
performance. If an investor buys an asset expecting a 10% return, the
likelihood that the return will be below 10% is the risk of that
investment. What this also means is that underperformance relative to an index
is not necessarily risk - if an investor buys an asset with the
expectation that it will return 7% and it returns 8%, the fact that the S&P 500 returned 10% is largely irrelevant.
What Is a Low or High-Risk Investment?
If investors accept the notion that investment risk is defined by a loss of capital and/or underperformance relative to expectations, it makes defining low risk and high-risk investments substantially easier.
A high-risk investment is one where there is either a large
percentage chance of loss of capital or underperformance, or a
relatively small chance of a devastating loss. The first of these is
intuitive, if subjective - if you were told there's a 50/50 chance that
your investment will earn your expected return,
you may find that quite risky. If you were told that there is a 95%
chance that the investment will not earn your expected return, almost
everybody will agree that that is risky.
The second half, though, is the one that many investors neglect to
consider. To illustrate it, take for example car and airplane crashes.
The odds of any driver experiencing a car crash in their lifetime is
quite high (25%), but the odds of death are relatively low (less than
1%). By comparison, the odds of experiencing a plane crash are quite low
(one-hundredth of 1%), but the odds of dying in a plane crash are quite
high (about 67%).
What this means for investors is that they must consider both the
likelihood and the magnitude of bad outcomes. Low-risk investing not
only means protecting against the chance of any loss, but it also means
making sure that none of the potential losses will be devastating.
Low Vs. High-Risk Investments For Beginners | Investopedia
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