Get new articles by email:

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning.

Join over 21,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

A Meaningful Definition of “Risk”

This is the 3rd and final post (for now anyway) in my ongoing discussion of risk. The first two explained the difference between risk and volatility and the problem with saying “risk” when we really mean “volatility.”

In my experience, most people define “risk” as “the chance of losing money.” I’ve always found this definition to be both insufficient and imprecise.

“Losing money” isn’t necessarily significant.

This one seems obvious to me. In order for something to be “risky,” isn’t it necessary that the potential loss is significant?

For example, let’s say your 7-year old daughter wants to start a lemonade stand. She asks you for $20 to help with start-up costs, and offers you 25% of the profits in return. It’s a near certainty that you’re not actually going to make money on this venture. (Selling greater than $80 of lemonade seems unlikely.) But would you really call it risky? Do you really care if you don’t get your $20 back? Of course not.

Another example: Let’s pretend for a moment that you’re a billionaire (Congrats!), and a close friend of yours asks you to invest $10,000 in his new start-up company. Is this a risky move? I’d argue that it’s not. Sure, there’s a significant chance that you’ll never see that money again. But even if the company completely fails and you lose all $10,000, do you really feel the impact?

It seems, to me, that we need to add something to our definition of risk to account for the significance of the potential loss. It’s also apparent that we need to account for the fact that significance is entirely relative. A significant loss for me may be insignificant to you.

But there’s still something missing…

By defining “risk” as the chance of loss, then any plan/strategy with a 0% chance of loss must be free of risk. Right? I bet you can guess how likely I am to agree with that. 🙂

Mathematical analysis tell us that in order to retire, you need to have saved 20-25 times your annual expenses. By investing exclusively in “no-risk” investments like CDs and savings accounts, you practically assure that you’ll never get to that level of savings. As a result, you’re more likely to run out of money during retirement. Now that sounds risky to me.

So perhaps risk isn’t likelihood of loss, per se. Or, at least, not about loss of money. Perhaps it really revolves around loss of options: The option to retire, the option to travel in retirement, the option to leave money to your kids or to charities, etc.

For the moment, here’s my working definition of risk:

Risk: The probability that an investment strategy (when followed) will render you incapable of meeting your goals (financial or otherwise).

I feel like that’s a better definition than “probability of losing money”, but I’m sure it could be improved upon. Any thoughts or suggestions?

New to Investing? See My Related Book:

Book6FrontCoverTiltedBlue

Investing Made Simple: Investing in Index Funds Explained in 100 Pages or Less

Topics Covered in the Book:
  • Asset Allocation: Why it's so important, and how to determine your own,
  • How to to pick winning mutual funds,
  • Roth IRA vs. traditional IRA vs. 401(k),
  • Click here to see the full list.

A Testimonial:

"A wonderful book that tells its readers, with simple logical explanations, our Boglehead Philosophy for successful investing." - Taylor Larimore, author of The Bogleheads' Guide to Investing

Comments

  1. Nice writing. You are on my RSS reader now so I can read more from you down the road.

    Allen Taylor

  2. Hi Allen.

    Happy to hear you enjoyed it. 🙂

  3. Great article, Mike! Thanks for the link as well!!

    Many people don’t realize how detrimental they can be to their own goals when they pursue the “safe” investments instead of a well-diversified, low-cost, tax-efficient portfolio. Avoiding the stock market because you’re scared almost guarantees that you’ll be unable to meet your goals unless you can earn a TON of money over your lifetime or you have very, very attainable goals (retirement income of $20,000/year before taxes).

    When you talk about the risk of any investment, you also have to look at the risk of not achieving your goals.

  4. Just wanted to say I love the site! I saw your articles on tipd.com. I’m a big fan of “common sense” finance and investing tips, so you’re one of my new favorites.

    Keep up the good work.

  5. Hi David.

    Thank you! Definitely good to hear that people like what I’m writing.

Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a registered investment advisor or representative thereof, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2022 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy

My new Social Security calculator (beta): Open Social Security