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What is Investment Risk, Really?
One of the most central concepts in investing is that of risk. But, remarkably, there is no widespread agreement on precisely what investment risk is. And, to make matters worse, the most common definitions of investment risk don't help investors to understand the single biggest financial risk that they face.
An investor trying to understand investment risk is liable to be quite confused by the myriad definitions out there. Below is a sampling of some of the most frequent views of investment risk.
The Balance: "When investing, risk refers to the possibility that an investment will lose value instead of gain value over time."
Economic Times: "Investment risk can be defined as the probability or likelihood of occurrence of losses relative to the expected return on any particular investment."
Investopedia: "Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return."
Securities and Exchange Commission (SEC): "In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision."
National Council on Aging: "One definition is simply the possibility of losing money on an investment. Another is the probability that the actual return of an investment will differ from its expected return. A third definition is the variability of returns from an investment compared to the investment’s average return (this means returns go up and down more than expected)."
Cambridge Dictionary: "the chance of losing money from a particular investment"
CFA Institute: "Common measures of risk include standard deviation or volatility; asset-specific measures, such as beta or duration; derivative measures, such as delta, gamma, vega, and rho; and tail measures such as value at risk, CVaR and expected loss given default."
Investment Analysis and Portfolio Management, by Reilly (1994): "Risk is the uncertainty that an investment will earn its expected rate of return."
We can classify these definitions as being in one of two categories.
Possibility of an investment losing money or value
Uncertainty in an investment's return
Both of these views of risk can help investors to better understand investment risk, but both have shortcomings as well that should be recognized.
Regarding #1, most investors are certainly concerned about the possibility of an investment losing value. We would always like our investments to gain value over time. But sometimes, investors voluntarily make an investment that they know will lose value over time. For instance, from April of 2020 until May of 2022, the real (i.e., after inflation) yield of 10 year Treasury Inflation Protected Securities (TIPS) was negative (as was the expected real yield of 10 year Treasuries, which are nominal bonds). This means that those buying 10 year TIPS during that time knew that they would lose buying power, relative to inflation, on a pre-tax basis if they held these TIPS until they matured. Did that make TIPS an obviously bad choice during this time? No. Rather, it simply meant that the cost of buying a guaranteed, inflation-adjusted, future payout was higher than it had been before. So, an investment losing value over time is not necessarily a risk; sometimes, it is a known outcome.
There's another problem with #1: an investment that is guaranteed not to lose money can still lose value (i.e., buying power). For instance, those who bought 10 year Treasuries on July 26th, 2020, are contractually guaranteed that their investment will return a nominal rate of 0.535% (assuming they hold these bonds until they mature). Unless the U.S. Treasury defaults on these bonds, there is no risk to investors losing money with them. But they hold significant risk due to inflation. Since there is no upper limit to how high inflation can be, nominal bonds like 10 Treasuries are completely exposed to inflation risk. It's partly for this reason that famed investor Warren Buffett has long argued that a substantial allocation to bonds actually amplifies investors' risk. Due to the existence of TIPS, which I believe are generally superior to nominal bonds for investors, I don't entirely concur with Buffett on this point, but I agree that trying to avoid the risks associated with something like stocks can increase some of the other risks investors face.
Regarding #2, uncertainty in the return we will get from an investment certainly can be a risk. Not knowing what our return will be means that we don't know how much we need to invest to reach our goals, making planning difficult, and if the return is poor enough, we may not be able to reach our goals at all. But uncertainty is not necessarily a risk, especially if the uncertainty is in upside potential. For instance, if an investment might return anywhere between 4% and 10% annually, and our investment goal only requires a 3% annual return, the uncertainty in not knowing what our return will be is not a risk. If someone offered you a free chance to win either $1,000 or $1,000,000, you wouldn't consider the high uncertainty in the outcome to be a risk.
As an extension of treating risk as uncertainty in returns, the academic finance community has largely treated risk as equivalent to volatility and something that can be easily measured after the fact with metrics like standard deviation. But this has some major problems. Peter Martin said the following about the standard deviation and the chart below he created.
"The calculated value of [the standard deviation (SD)] is not affected by the sequences in which gains and losses occur. Thus, SD does not recognize the strings of losses that result in significant drawdowns in value. The three hypothetical investments in the chart below have the same annualized return (-0.52%/year) and the same SD (4.66%/month), but no rational investor would consider them as having the same risk."
In the chart above, Martin took the returns from a real fund (the blue line), and reordered them in two ways, one where the returns were ordered from worst to best (the pink line) and one where the returns were reordered to be as smooth as possible (the yellow line). Despite all the lines having identical standard deviations and cumulative returns, Martin was quite correct that no rational investor would consider the risks of such hypothetical investments to be equal.
In sum, there is value in both of the most common view of investment risk. Investors certainly want their investments to gain value over time, but this is not always possible, and it's vital to keep in mind that an investment can gain money and simultaneously lose buying power. Uncertainty or volatility in the returns of an investment certainly matter, but most investors aren't much concerned with 'upside volatility' (i.e., an investment making significant but erratic gains).
But, in a real way, both of these definitions largely ignore the single biggest financial risk that investors face: the risk of not being able to fund their needed expenses in the future. After all, the underlying purpose of saving and investing is to fund future consumption, and the various risks that investors face are, in the end, subservient to this risk.
For this reason, of all the definitions of investment-related risk that I've seen, the one I prefer the most is from the Financial Industry Regulatory Authority (FINRA): "Risk is any uncertainty with respect to your investments that has the potential to negatively impact your financial welfare."
Being able to fund one's needed expenses in the future is itself dependent on many factors, which I will explore in the future. But the possibility of losses in one's investments and uncertainty in their future value are only part of this holistic assessment.
