Investors oversimplify the concept of risk. The financial industry has persuaded us that risk is a singular noun that can be described quantitatively as a constant on a linear scale. Investments are presented as high risk (stocks), medium risk (bonds), or low risk (CASH). Financial professionals might even discuss something called the risk-free rate of return, which implies that risk can be totally eliminated with certain investments (T-bills). Brokerages and financial advisers provide clients with questionnaires to help determine where an individual investor resides on this linear scale. Once that answer is derived, then the investors' portfolio can be determined. Some investors will opt for the aggressive portfolio, others for a conservative portfolio.
The type of risk denoted above describes volatility, which is much easier to measure and model than the risks faced by most investors. Important considerations are ignored. For example, what is the risk that you will outlive your financial resources? This risk works in an opposite direction to risk as conventionally defined. Most investors will not reach their financial goals by investing in only the "safest" securities, because the returns on those securities are too low. By lowering one kind of risk, they are raising another.
Or consider the risk of a concentrated portfolio. Although this type of risk is perhaps the easiest to address, many investors have still not learned the lesson to diversify their portfolios. How many users of Apple products have too high a percentage of their wealth tied up in a single company's stock? Are they aware of the risks they are taking? Where does this type of risk fit on the linear scale? In the October 2001 Journal of Finance, Shlomo Benartizi reports that Coca-Cola (NYSE:KO) employees directed more than 75% of their discretionary contributions into their retirement plans into company stock (page 1747). Is it prudent to disproportionately bet your financial future on the success of a single company?
Consider the prototypical grandmother whose entire portfolio consists of AT&T (NYSE:T) stock and a bunch of CDs. How is this portfolio positioned to deal with inflation risk when the rates of return on her investments don't keep pace with the devaluation of the currency?
Bond investors are concerned about the risk of rising interest rates. For a corporate bondholder, this risk can be eliminated by buying and holding individual bonds to maturity. But this increases credit risk by concentrating on a few companies, compared to investing in a more widely diversified bond fund. Although there is no way to totally eliminate risk, sometimes it can be moved around from one type to another.
Liquidity risk is a concern for investments in privately-owned real estate or private businesses. If most of one's assets are tied up in such entities, this could present problems if the investor encounters a situation where he needs cash in a hurry.
How about the risk that your financial adviser or hedge fund manager is gambling with your money? He profits from any gains, but you are stuck with the losses if his bets don't work out so well. What risk did Bernie Madoff's clients ignore when they let him manage their money? Where would this type of risk fall onto the linear spectrum?
Another risk that is more difficult to judge is the risk of being swept up by the emotions of the crowd. For example, the buyers of Internet stocks in 1999 and early 2000 are still licking their wounds today. Many of those who panicked and sold stocks in latter 2008 and early 2009 have watched from the sidelines as stocks have more than recovered all the losses incurred in the crash. The psychological risk of making such emotional decisions should not be ignored, just because it is difficult to measure.
The inconvenient fact is that there are many different types of risks, and their magnitudes and relative importance change as both markets fluctuate and people's lives undergo significant change. Some of these risks are interdependent with others. Reducing some types of risk increases others. It is shortsighted to combine them all into one simple, unchanging number that is assumed to perfectly determine the risk appetite of an investor or the risk profile of a portfolio.
There is nothing wrong with using a spectrum to describe risk, but instead of a single spectrum, one needs to think in plural terms-spectra. Each type of risk can go from low to high and the task of the investor is to make reasonable tradeoffs. For those who have not been keeping score, here is a list of the risks I have touched on that many investors should at least consider from time to time. It is not totally inclusive-additional risks may be appropriate in some situations.
- Volatility risk (risk as conventional presented)
- Risk of outliving your financial assets
- Concentration risk
- Interest rate risk
- Inflation risk
- Credit risk
- Liquidity risk
- Risk of receiving poor or overpriced advice and portfolio management services
- Risk of dealing with dishonest parties
- Risk of panicking and doing something really stupid in extreme markets
The next time you encounter a discussion of financial risk, consider the deficiencies of treating it as a singular noun. With apologies to those who want simple solutions to complex problems, oversimplifying risk is simply risky behavior.