What Exactly Is Risk: Part II

Apr. 18, 2014 7:31 AM ETSPY, SSO, SDS, VOO, IVV, DIA43 Comments
Larry Swedroe profile picture
Larry Swedroe


  • The expected return of a portfolio should never be considered as a single point, but instead, should be considered as a potential distribution of outcomes.
  • Tracking error, black swan and maverick risk are a few other ways to define the risk that investors and advisors face.
  • Standard deviation isn't the only risk investors and advisors should consider when developing a financial plan and investment policy statement.

Today concludes our two-part feature that aims to define risk. Not being able to do so is a problem for both advisors and investors.

Alternative Definition of Risk

Risk can also be defined as the probability of not achieving your financial objective - with the objective generally being not the accumulation of the greatest wealth, but instead, having sufficient wealth to allow for the maintenance of an acceptable lifestyle (and not run out of funds while still alive). It's important to note that the expected return of a portfolio should never be considered as a single point, but instead, should be considered as a potential distribution of outcomes. The use of a Monte Carlo Simulator can help with estimating the risks (odds) of failure.

Tracking Error

Another type of risk, one that is purely psychological, though real nonetheless, is what is known as tracking error risk. For example, U.S. investors that build globally diversified portfolios will experience investment results that are quite different than those experienced by the "market" - with the market defined as a broad major index such as the S&P 500. Some years (i.e., 2000-03), investors will like the divergence, as the tracking error is positive. Other years, they may be unhappy with the divergence (1998-99), as the tracking error is negative. Negative tracking error can lead to loss of discipline. Thus, investors that are sensitive to the risk of tracking error should consider either minimizing it or avoiding it altogether.

Black Swan

Another risk that should be carefully considered is that of the unexpected negative surprise - the appearance of the so-called "black swan." Unfortunately, one of the most common and costly mistakes made by investors/advisors is to treat both the highly unlikely as impossible and the highly likely as certain. Prudent investors know that history teaches us that just because something

This article was written by

Larry Swedroe profile picture
Larry Swedroe is head of financial and economic research office for Buckingham Wealth Partners,  a Registered Investment Advisor firm in St. Louis, Mo.. Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College. To help inform investors about the passive investment approach, he was among the first authors to publish a book that explained passive investing in layman’s terms — The Only Guide to a Winning Investment Strategy You'll Ever Need (1998 and 2005). He has authored seven more books: What Wall Street Doesn't Want You to Know (2001), Rational Investing in Irrational Times (2002), The Successful Investor Today (2003), Wise Investing Made Simple (2007), Wise Investing Made Simpler (2010), The Quest for Alpha (2011), and Think, Act, and Invest Like Warren Buffett (2012). He also co-authored eight books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006, with Joe Hempen), The Only Guide to Alternative Investments You’ll Ever Need (2008, with Jared Kizer) and The Only Guide You’ll Ever Need for the Right Financial Plan (2010, with Tiya Lim and Kevin Grogan), Investment Mistakes Even Smart Investors Make (2011, with RC Balaban), The Incredible Shrinking Alpha (2015 and 2020 with Andrew Berkin) Reducing the Risk of Black Swans (2013 and 2018 with Kevin Grogan), Your Complete Guide to a Successful and Secure Retirement (2018 and 2020 with Kevin Grogan), and Your Essential Guide to Sustainable Investing (2022 with Sam Adams). He writes for AdvisorPerspectives.com, AlphaArchitect.com, and TheEvidenceBasedInvestor.com. You can follow him on Twitter  (http://twitter.com/larryswedroe).

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