What Exactly is Risk?

The statement “all investments have risk” seems straightforward.  All investors seem to understand this.  But what exactly is risk?

For you, risk might mean the loss of money invested due to market fluctuations.  And if this is what you worry about, then what is the right time frame to judge the risk?  Is it daily, monthly, quarterly, annually, or perhaps a longer period of time?  Loss of money has two dimensions – depth and duration – so risk is directly tied to how you answer this question: For how long can you tolerate losing money?

As the chart below shows, the U.S. stock market since 1980, as represented by the S&P 500, has its ups and downs (the grey bars display the annual returns).  While the market delivered positive returns over 75% of the years shown, there was quite a bit of fluctuation in the process.  The red dots show the largest peak to trough decline during each year.  For example, last year the S&P 500 rose 30% (excluding dividends) but at one point during the year it declined 6% from a high point to a low point.  On average the market experiences a drop of about 14% during each year. The worst decline during this 34 year period was the 49% drop during the 2008 financial crisis.

image1 Jan 2014

Clearly price declines represent some form of risk.  But why do we invest in stocks in the first place?  Well, generally investors are seeking some growth of their capital.  This is needed over time since the cost of almost everything we buy goes up and the purchasing power of our money goes down.  Therefore, it is important to “take some risk” in order to protect our capital from the consistent ravages of inflation.  When looking at risk through this lens, risk isn’t measured by the regular and significant stock market volatility, but rather by the certainty of the erosion in the purchasing power of our money.  Therefore, it becomes risky not to invest.