The Definition of Investment Risk

Jun 2014 //
Risk vs. Volitility
Behavioral Finance

…let’s agree on a simple definition of risk.  To us, risk is the likelihood (possibility, probability, etc.) that you will not be able to achieve your objectives.  Therefore, the concept of risk is essentially meaningless without having some objective(s) in mind.  For example, consider these possible investment objectives:  (1) avoiding negative returns, (2) avoiding after-inflation negative returns, (3) avoiding after-inflation, after-tax negative returns, (4) making your money grow to the point that you have an adequate retirement nest egg, and (5) trying not to outlive your money.  For many people, the first of these objectives is relatively easy to achieve, though it may come at significant cost in the form of very low nominal returns (and perhaps negative returns after-inflation).  The second objective is harder, and the third, fourth and fifth objectives are increasingly more difficult to achieve. …A common perception is that stocks are basically riskier than most bonds and bank deposits.  Put differently, the perception is that most bonds and bank deposits are safer than stocks. …[However,] if you want your investments to maintain (or increase) your purchasing power, or if you want to avoid outliving your money throughout your retirement years, then for many people bank deposits and most bonds are risky and stocks are safer.  You read that right.  Depending on your investment objective, bonds can definitely be riskier than stocks, because bonds often lack the rate of return potential necessary to achieve growth after inflation and taxes.