Introduction

Risk and reward are inextricably intertwined. Do not expect high returns without high risk. Do not expect safety without correspondingly low returns.

–William Bernstein1

Uncertainty

Uncertainty is when an outcome (or the probability thereof) is unknown. Uncertainty isn’t necessarily bad. For example, uncertainty in equities can be a good thing if your financial result exceeds your cost basis plus your investment’s opportunity cost (i.e. your “gain”).

Risk

In finance, risk is best defined as consequential or nontrivial uncertainty.  In other words, “uncertainty that matters“, such as the possibility of damage, loss, or a similar undesirable event. For example, you may fear losing money on your investments and the consequences thereof. Risk tolerance is subjective. If, hypothetically, there were no negative outcomes, then you could take on considerable uncertainty without any risk.2

When analyzing your risk, you should ask:

1. Where is your risk?
2. How significant is your risk?

Quantifying your risk requires you to assess its probability and its cost, if that risk occurs.

Equities

For equities, there are three different types of investment risk:3

1. Market risk: this is the risk underlying the total market;
2. Market sector risk: as the market expectations for a particular industry change, this is the risk that the value of all companies in that sector may be negatively impacted4; and
3. Individual stock risk: this is the risk that an individual stock’s value might fall because it was priced too high when you purchased it, because the company misses expected earnings, or because the company goes out of business.5

You can diversify away individual stock and stock group risks by purchasing an index fund. Therefore, there is no incremental value to taking on individual stock and stock group risks.

Market risk, by contrast, will always be there. You can manage market risk by selecting less volatile securities, by keeping part of your portfolio in cash or by borrowing less. But you cannot eliminate market risk.

One of the most fundamental investment decisions that you will make is deciding what level of market risk that you want in your portfolio. This is encapsulated in your asset allocation, notably the ratio of your equity to fixed income investments.

Bonds

Similarly, for bonds, there are individual bond risk and bond group risk. Bond risks include the potential for default or being called. Bond ratings agencies may make rating errors, especially regarding group risk. Both individual bond risk and bond group risk can be diversified away by investing in a total bond market fund. In addition to protecting you from risks of particular issuers or types of issuers, this will defend your portfolio against changes in interest rates.

Volatility

Risk is commonly considered a synonym for volatility. However, they are not the same thing. If your confidence in an expected outcome is high enough, then volatility actually can be a good thing provided that your timeline is long enough to realize the expected outcome.6

As Warren Buffett observed,

Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.7

Volatility is commonly quantified in terms of the standard deviation of annual returns of a portfolio of securities from their long term average. The higher the standard deviation, the greater the risk assumed in your portfolio.

The normal range of standard deviation of annual returns follows:

conservative	no more than 8%
moderate	no more than 15%
aggressive	no more than 20%

No one should have a standard deviation greater than 30%.

The 68–95–99.7 Rule is an easy way to remember the percentage of values that lie two, four, and six standard deviations, respectively, around the mean in a normal distribution. Said differently, roughly two thirds of the time, the annual return (gain or loss) of an investment will be between one standard deviation above and one standard deviation below the mean.

Focusing solely on your downside volatility (i.e. how most investors think of risk), you have the following chances of loss based on standard deviations:

1 standard deviation	1 in 6
2 standard deviations	1 in 44
3 standard deviations	1 in 740

This is why it is so important to first identity the standard deviation of annual returns of any investment. The lower the semivariance, the less likely that you will have a large loss.8 Remember to always think defensively. You cannot predict when market downturns will happen but you should design your investment strategy knowing that they will occur.

Your primary goal is to avoid making mistakes. Understand your own risk tolerance, particularly when markets are volatile. Don’t succumb to greed or fear. Stay the course with your desired asset allocation.

Assessing Your Risk Tolerance

Charles Ellis recommends that you ask yourself six questions:9

1. What are the real risks to you of an adverse outcome, particularly in the short run?
2. What are your probably emotional reactions to an adverse experience? (informed tolerance)
3. How knowledgeable are you about the history and realities of investing and the realities and vagarities of the financial markets?
4. What other capital or income resources to you have and how important is your investment portfolio to your overall financial position?
5. Are there any legal restrictions on your investments?
6. Are there any unanticipated consequences of interim fluctuations in portfolio value that affect your optimal investment policy?

Vanguard has a useful questionnaire here so that you can better understand your risk tolerance.

Summary

Coming soon!

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Updated on February 13th, 2019