What is Risk? Not as obvious as it might seem!

Taking Risk

Risk is a scary word thrown around a lot in the investment community.  Go to the bank they’ll talk to you about risk.  Go to a government website on investing and they’ll talk about risk.  There’s a big problem though:

Not everyone means the same thing when referring to risk.

I’m going to illustrate this point by asking you to refer to your common sense.  We’ve all heard the phrase “the greater the risk, the greater the reward”.  Let’s put that into the context of a sports team and try applying the same logic.  A sports team is going to a game and I say “the greater the chance of losing the better the chance of winning”.  Does that make any sense?  No, it makes no sense at all.

Why do I use this example?  Because it proves that the definition I believe most people care about when referring to risk isn’t the definition we generally hear.  Before we look at that definition though let’s look at the two other common definitions of risk.

When a bank says “risk” they are generally talking about volatility.

What is volatility?  It’s the amount the value will shift up and down.  For example, a GIC doesn’t shift up and down; it is always worth its face value, so it is described as “very low risk”.  A bond on the other hand might vary in value over time but ultimately is worth the face value so it is “low risk”.  A fund of stocks will vary wildly, it could swing 10-20% in either direction so it’s considered to be “medium risk”.  An individual stock on the other hand could double in value or lose all its value, so it’s considered “high risk”.  An option is like a stock but moves even faster because of leverage so it’s “very high risk”.  According to this definition the statement that “the greater the risk the greater the reward” is true because the more the value can change the farther it can go up and the farther it can go down.  This doesn’t mean it’s likely to do either of those things, just that the potential is there.

Volatility is not risk, volatility is volatility.​​​​

How do I know the above statement is true?  Because if we pick a bunch of investors and ask them whether they mind that the investment is going to go up and down a lot so long as it goes steadily up by a fair amount will they care much?  In general, no.  In other words, the average person isn’t concerned so much with how much the investment is fluctuating; they care whether they lose money!

In that sense volatility does add some risk, because you don’t know what it will be worth at a particular point in time when you might need to sell an investment.  But it’s a component of risk, not risk itself.

Let’s look at the next definition:

When the government says “risk” they generally mean “exposure”,

Exposure and volatility are linked and exposure and risk are linked, but before we explore that let’s talk about what exposure means. Exposure essentially refers to how significantly changes in the market will affect the amount of money you have. By this definition cash is virtually a risk free “investment” (I’ll show later how it’s the exact opposite but we’ll get back to that).

To understand this concept let’s compare four investment classes: options, mutual funds, principle protected notes, and a GIC:

  1. Options – in the case of an option a small change in the market results in a large change in the amount of money you make, in other words your money is very exposed
  2. Mutual Funds – in the case of a mutual fund a change in the market results in a more or less equivalent change in the value of your investment
  3. Principle Protected Notes – in a principle protected note there are two components, the first is the portion that’s directly exposed to the market, the second is the part protecting your investment, as the market changes over time this ratio can change meaning fluctuations in the market can impact your return less than the total fluctuation itself
  4. GIC – in this case the value doesn’t change at all, it is fixed along with the return

Note that according to the government definition the top most (options) are the most risky and GICs are the least risky.  This is perhaps a better definition than volatility, but still not perfect, because it still doesn’t really address the thing I believe most investors (myself included) consider important, which is our definition:

Risk is the probability of loss.

What I really care about as an investor is “what is the chance that I’ll lose money?”  And the second question is “how much money might I lose?”, in other words “how much am I risking?”.  Is it fair to say this is actually what you care about when you’re thinking of risk?

Using this definition let’s re-examine some of the basic investments and then go look at some of the less conventional ones.  When buying a GIC what is the chance I’ll lose money?  About as close to zero as you can get, the only real risk is inflation, so a GIC is legitimately low risk, likewise for a savings account.  How about a mortgage, if I lend money on a private mortgage what’s the chance I’ll lose money?  Relatively low because I have the property backing it, more importantly, the amount I’ll lose is limited, this is why banks lend money at their lowest rates on mortgages.  What about a mutual fund?  Generally, a mutual fund has two things going for it.  First, if you can afford to hold it long enough you probably won’t lose money, so it’s sort of medium risk (we’ll get into more details here in a moment), so the risk in a mutual fund is really the volatility risk.  Second, a mutual fund is structured in such a way that you can’t lose all of your money, so in that sense it’s lower risk.

Now, I don’t want to get into individual stocks, options, real estate, etc. just yet because here we get into nuances, which is according to this definition we’ve stated we can no longer evaluate risk by investment class, we need to do it on an individual basis.  In other words, not all blue chip stocks have the same risk.  Not all real estate has the same risk.  Not all options have the same risk.

There will be several posts to follow on this subject but just to illustrate the point, if I buy a property for less than it’s worth does my risk go up or down?  It goes down.  If I buy it for more than it’s worth does my risk (probability of losing money) go up or down?  It goes up.  The same is true for stocks, bonds, options, etc.  The point is once you’ve learned this definition of risk you can start to look at different ways to mitigate that risk and not just paint all investments within a given class with the same brush.  This is how you get superior returns.

If you’ve got investing questions you’d like to discuss or like us to cover please click in the lower right corner of the screen to send it to us, looking forward to hearing from you.

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