What we talk about when we talk about risk

The word ‘risk’ is among the most loaded in the English language.

In our world of personal wealth it has many meanings, but ‘risk’ really comes down to two principal applications and can be best defined through two questions:

1. What are the chances of permanent loss of capital?
2. What are the chances of reduced purchasing power over time?

Whenever we recommend a course of action it is almost always in reaction to one of the above two concerns, usually both.  Below I will discuss the first part, and leave the second for my next post.

Let’s use a specific example.  A person invests her life savings to open a deli.  She does it because she believes she has the perfect recipe for the reuben sandwich that has somehow eluded the last 437,000 people who opened delis before her.  In doing this she runs the risk that the world disagrees with her, and a year later the deli is gone and so are her life savings.  This is an extreme example but a common one; the capital was invested in the hope and expectation of growth but instead it’s gone and is never coming back.

If a person were to invest their entire 401k plan into their company’s stock, there is little conceptually different from the above example.  Yes, their company is likely larger, better capitalized and has a longer history of profits than our deli but the chances of the business continuing in perpetuity are slight.  Not convinced? Ask a former shareholder of GM, Lehman Brothers, Washington Mutual, Enron, you get the point.

There are two primary defenses against the permanent loss of capital.

The first is diversification. Accepting the idea that some of your investments will go south is easier when it’s a small fraction of hundreds or thousands of companies.  Owning an index or an asset-class fund assures you that the failure of any one company is insufficient to knock your investments off track.

The second defense is slightly more complex: it means that you as an investor must not make demands on your portfolio that it is unable to meet.

Huh?

An investor who is saving money that will not be spent for decades can withstand volatility in the portfolio that someone who spends money off the portfolio every day simply cannot.  Our saver/investor who is adding to the portfolio every month should not care one whit about the next 40% downturn in the stock market because she will be a BUYER of stocks for the next several decades.

Our prosperous retiree who spends money every month (bills are pesky that way) better have enough in cash and other non-volatile assets to cover expenses without having to sell temporarily depressed assets.  If you sell an asset in order to cover your life’s expenses, that is capital that can no longer be invested and is gone forever.

Ultimately money is here to serve us and not the other way around.  Understanding risk and how it affects your investments and your life is an important step in coming up with the best possible solution for you.