Wax On Wax Off: The Real Definition of Risk

May 22, 2020

You hear financial commentators often talking about the notion of risk in referencing asset classes. 'The market was higher today and telling us the risk trade is on…' or 'Investors took risk off the table this week by shifting into bonds from stock.' Another common reference to risk relates to how volatile the market is in the near term as evidenced by comments like, 'I expect the markets to be a lot more volatile and riskier leading up to the next Fed meeting….'

But is the ownership of stocks, and the short-term movement thereof, the best definition of risk? Or even a good one? Let's examine more closely.

Two investors own the S&P 500 (SPY). One is saving to buy a house in 6 weeks, the other for retirement in 20 years. They both own the same asset - the SPY - but are they taking equal risk? In the first case, the investor is taking the risk that his stock holdings will be worth less in 6 weeks than today and thus he won't have enough money for his down payment. The 2nd investor is taking no such risk. In fact for him, he would be taking risk if he weren't invested in stocks since if he keeps his retirement funds in cash for the next 20+ years, he risks not having enough purchasing power in retirement to cover his expenses. So, for the first investor, being invested in SPY is a source of risk whereas for the 2nd investor not being invested in the same equity is a source of risk. So clearly the asset itself is not the source of risk, but rather the holding period (time).

Lesson: match your assets (stocks, cash, bonds, etc.) with your time horizon and you materially mitigate asset holding risk. If you need the money to pay your mortgage next month (or anytime the next couple years), keep it in cash and thus you are not subject to short-term stock declines (risk mitigated). For funds you don't need for many years, near-term stock price movements are of no relevant concern, so again, day to day stock market volatility is no longer a risk. The only time volatility becomes a risk is if you turn your long term holdings into short term holdings by deciding (or worse yet being forced – see below) to sell in the near term what you had planned to hold for the long term.

Other common forms of true risk include leverage. If everyone owned their homes outright in 2007-2009, there would have been essentially no foreclosures. It was excessive leverage that forced people to sell real estate into weakness. Often when the stock market is tanking, people are forced to sell at just the wrong time not because they want to, but they have to: they get a margin call from their broker and that exacerbates the broad selling. Another form of risk is concentration of position. If you have too much in one holding and that equity goes south, you have taken on undue risk. An additional common source of true risk is overpaying for an asset. As the definition of investing is (or at least should be) setting aside a dollar today with the reasonable expectation of receiving more than a dollar (after dividends and price appreciation) in future years, if you overpay for any given asset, you lengthen the time it may take to get that reasonable return. Which is why, although counter-intuitive from an emotional standpoint, you are actually taking on less risk in buying stocks when they are down materially as they were back in late March than when you purchase them at higher valuations as they were trading in January of this year. It may feel like you are taking on more risk buying stocks when headlines are dire and the market is bleeding red day after day, but mathematically you have reduced your risk vis a vis an investor who purchased the broad market at a higher price. Look at it in the extreme – imagine someone gifted you their S&P 500 holdings for free. Stocks could drop 50%, 60% or more and you would still be ahead.

The ultimate definition of taking risk is not knowing what you are doing. If you dropped a skilled ocean swimmer 3 miles offshore she would be taking very little risk in returning to the beach, whereas the average adult might be risking his life since he does not have the skill necessary to make it back. For the skilled swimmer, not being challenged with the 3-mile swim may actually be a risk relative to their desired outcome of being prepared to swim the English Channel, for example. Thus, it is clear that risk is not absolute. It is different for everyone, even engaging in the very same activity or buying the very same stock.

It is very important that you assess your specific circumstances when determining the right course of action, the true risk you are taking. Listening to a financial pundit talk about how risky the market is and taking/not taking action based on his general commentary could be very detrimental to your future financial health. Remember, talking heads on TV – even very smart ones – are not being paid to manage your money. They are compensated to give general opinions, often on short term market moves, none of which is likely applicable to you. Thus work with a professional who knows your specific circumstances and can give you prudent, rational, fact-based advice accordingly while ignoring the emotions-driven noise blasting over the airwaves.