Author Topic: What Is Risk?  (Read 1883 times)


  • 5 O'Clock Shadow
  • *
  • Posts: 1
  • Age: 64
  • Location: Grand Rapids, MI
What Is Risk?
« on: May 16, 2017, 02:23:48 PM »
I have a question that has bothered me since I spent an afternoon getting sold by a financial planner dude. He went into modern portfolio theory and I ate it up like candy. When he talked about risk I noticed he conflated risk with the variance in asset price. (That makes some sense. If I were a finance dude I'd seek a mathy proxy for risk even if it didn't quite fit.)

A single stock price might vary widely as it circles the drain, but if I buy a total market index fund (e.g. VTSAX) I'm certain the entire market won't go bankrupt. If nothing forces me to sell in a down market, where's the risk? Stocks are nearly inflation-proof and the only risk I can see in holding VTSAX is a multi-year secular decline such as we've not seen since FDR was president. For this reason, I don't understand why an investor would lose sleep holding a 100% VTSAX portfolio.

The main challenge is ordering one's affairs so that expenses remain less than dividends. Am I missing something?


  • Handlebar Stache
  • *****
  • Posts: 1444
  • Age: 47
  • Location: Houston TX
  • Devour your prey raptors!
    • Financial Velociraptor
Re: What Is Risk?
« Reply #1 on: May 16, 2017, 02:55:20 PM »
Modern Portfolio Theory is controversial in some aspects.  Especially the idea that Beta = Risk.  If you leave the world of t-distribution statistics and move into Bayesian statistics, you might look for 'priors' to identify risk.  In that world, you'd define risk as: [loss of capital]. 

I did an MBA in Finance and "proved" with the ONE HIGH AND HOLY MATHEMATICS {AMEN}, that MPT is "true" absolutely ad nauseum.  I still don't buy the idea that Beta = Risk. 

It becomes even less true if you add asset classes other than equities to your portfolio.  I like to sell options for income.  This increases my Beta but lowers my capital at risk by the amount of premium collected.  Clearly, the Beta on my portfolio is less well correlated to risk than to a MPT index with T-Bill anchor.  You might have Real Estate, gold bullion, section 770 insurance plan, municipal bonds, a side business, etc. all with varying Betas and correlations to your action risk (if you can even define it).

MPT lets you do a lot of cute math.  That much math can make you miss the forest for the trees in my opinion.  Most people are still better off indexing in the lowest cost funds they can find.  Just don't get blinded by 50 years of egghead thinking.   


  • Bristles
  • ***
  • Posts: 464
Re: What Is Risk?
« Reply #2 on: May 16, 2017, 03:03:14 PM »
Welcome to the boards!

Risk, in my mind, is the probability of some black swan type event. Everyone can withstand a 5-10% correction, but can you stomach a ~60% correction? Your profile says you're 62 years old. How well would you sleep if your portfolio went down 60% over the next 2 years? What happens if you bail out at ~55% and then don't get back into the market until stocks have gone back up ~25%?

Anyone +/- ~2 years from retirement should be 50/50 stock/bond, IMHO. Then use a glide path to 100% stock over the next 10-15 years.


  • Bristles
  • ***
  • Posts: 452
Re: What Is Risk?
« Reply #3 on: May 16, 2017, 03:47:37 PM »
I come from a more anecdotal perspective when it comes to finances, but I agree with what's been said already.  I think it's important to distinguish between risk and volatility.  Risk is a partial function of volatility, but the two are not the same.

To me risk refers directly to the 'risk of ruin', e.g. the chance that I run out of money.  This is different than the measure of a given stock or ETFs variance or volatility over specific time frames.  One thing to keep in mind is that the risk of ruin is also a function of your average portfolio return.  In that sense, funds that have a higher rate of return (small-cap stocks) can actually serve to reduce your risk, even when then have a higher short-term variance.  Realizing this was a big 'aha' moment for me when it came to how I put together an investment strategy.

The main takeaway of all of this isn't actually that interesting.  In general, if you're in accumulation mode with a long term horizon, you want to prioritize average annualized returns independent of variance to minimize your risk.  If you're in retirement mode with a short term horizon, you want to lower your volatility, but only in proportion to your portfolio size.  If your spend rate is $40k/yr, you probably want to be more volatility-averse if you're sitting on $1M in assets.  On the other hand, if you have a $5M portfolio, you could care less about short-term fluctuations as your spend rate is so small compared to your assets.  This is all basically known as general financial common sense.

One final thing to think about during your accumulation phase is the double-whammy of a market crash coupled with a job loss.  This is what happened to many people in 2002 and 2008, and is something you need to be prepared for.  For must of us, this is the entirety of our risk, as no other combination of factors will lead us to financial ruin.  Thus, to me, minimizing risk means making sure I never run out of money.  That means making sure i would 1) be able to weather the storm of a job loss during a market decline during my accumulation years, and 2) retire with a portfolio guaranteed to see me all the way to my and my wife's death.  A third 'risk' that comes up that I believe is secondary to the previous two is 3) making sure I don't work more years than I need to, and I believe it's appropriate to try and minimize that risk only after the first two are addressed to a certain level of satisfaction.


  • Handlebar Stache
  • *****
  • Posts: 1425
Re: What Is Risk?
« Reply #4 on: May 17, 2017, 09:25:08 PM »
Traditionally, risk was considered related to leverage. A company that borrows to fund 80% of its assets is more risky than its twin that only borrows 20%. This is because leverage amplifies both positive and negative returns. If information suggests both companies will earn $1M more profit this year, the shares of the leveraged company will rise more than the un-leveraged company because in the leveraged company there are fewer shares to distribute the profits among. However, news suggesting both companies would earn $1M less would more adversely affect the leveraged company. Thus, as good and bad news swishes around, both companies' shares rise and fall, but the levered company would be much more variable - and thus its beta would be higher. Beta would be telling you "this company will probably go up or down faster than the market."

Beta was also traditionally thought of as a combo of systemic (market) risk and unsystematic (asset-specific) risk. You can pick a great company with low unsystematic risk, but if it's early 2008, the market risk is about to wipe you out anyway. Similarly, you could have bought Sears during this bull market, but the unsystematic risk of that company would have wiped out your investment despite the market. These outcomes might make it look like beta didn't matter, but beta is not for predicting outcomes, it's a ratio of covariance to the market.

This matters for the financially independent because, yes, you are forced to sell at bottoms! For example, if you went into 2008 with an all-stock portfolio and you were living off the proceeds, you would be forced to sell all the way down to cover living expenses each month, week, or whatever. Instead of selling 10 shares of X to keep the electricity on, you'd have to sell 20 (dividends were often cut or suspended, BTW). Those lowball sells would have decimated the future value of your portfolio, and caused you to miss much of the rebound. It's dollar-cost-averaging in reverse.

If your portfolio was high-beta, it would have been even worse because the shares you had to sell would fall further than low-beta shares, forcing you to sell more of them than if you had bought the low-beta shares. Maybe instead of selling 10 shares of Y, you have to sell 30. The shares may completely recover, but you won't.

For those aspiring to FIRE, this matters because we have to decide if we want to risk a recession or correction adding years of hard labor to our lives. Yes, the expected return of those high-beta stocks/portfolios is higher (see Capital Assets Pricing Model), which means we could plausibly escape cubicle jail a couple years earlier by embracing more risk. However, if the market takes a poo, we might have to work several more years thanks to our decision to go high-beta. It's like the prisoner's dilemma.

Beta is about the only quantitative metric for risk, so I am reluctant to toss it out in favor of ...what? ...opinions? ...intuition? ...smell? However, we should keep in mind beta is an objective measure of other investors' behavior. It assumes they rationally and consistently respond to the news. I'm not sure if that's true across time. Investors' sensitivity to things like rising interest rates, political instability, or widespread bankruptcies seem to change over time. These days, investors say "meh", but in other time periods, these news items might have justified a correction.

Just don't make the mistake of comparing beta across asset classes. A stock and its put option are not comparable in beta terms. One goes up and the other goes down and vice versa. Stocks and bonds are sometimes correlated, sometimes not. Also, don't make the mistake of thinking a portfolio of high-beta stocks averages out to the risk of a low-beta stock. They're correlated assets.

This time is not different, and the best you can do is (a) reduce unsystematic risk through diversification, and (b) select a level of risk / leverage / beta that you can live with through a large downturn. That's 55 year old advice, but don't be fooled into thinking something fundamental has changed.


  • 5 O'Clock Shadow
  • *
  • Posts: 73
Re: What Is Risk?
« Reply #5 on: May 25, 2017, 09:56:11 AM »
To me, risk is the probability of meeting your goals (ie. getting a desirable outcome vs. getting an undesirable outcome).  Obviously, there are nuances to this in that losing all your money in a black swan event is a much more undesirable outcome than being $10,000 short of your FI goal by your pre-set date.

People often use the term risk as a proxy for volatility, which doesn't make a lot of sense to me, since it doesn't necessarily translate into life goals.

For example, if I park $1,000,000 in FI money in cash under my mattress, there is almost no volatility since my $1 is still $1 in 30 years.  But in a real sense, the probability of the money under my mattress giving me real purchasing power to fund my retirement over 30 years is basically nothing due to inflation.  In this scenario, if you define "risk" as "volatility", then you would conclude that there is "no risk".  But if you define "risk" as the probability of getting a desirable outcome, then you would conclude that there is "high risk".

Sometimes volatility does equal risk.  If I have $100,000 downpayment for a house that I want to buy in 1 year, and I put my $100,000 in the stock market, there is a high probability that I won't have $100,000 by next year for my downpayment due to stock market volatility.  In this case high volatility = high risk by my definition.
« Last Edit: May 25, 2017, 10:00:07 AM by pumpkinlantern »