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Conflicting Definitions of Risk

  • Finance world’s definition of risk: The likelihood of less-than-expected returns. (Or, “unpredictability/variance of returns.”)
  • Rest of the world’s definition of risk: The likelihood of negative returns. (Or, “the chance of losing money.”)

In my opinion, this is a problem. The finance community uses the word “risk” to mean one thing, while the rest of the world uses it to mean something different (but sufficiently similar to cause confusion).

Contrived Example #1: A particular investment earns a +50% return in 1/3 years, a +100% return in 1/3 years, and a +150% return in 1/3 years. According to most people’s use of the word “risk,” this investment is risk-free. In fact, it’s the best thing they’ve ever heard of!

But according to the official finance definition, this investment is high-risk: Its returns fluctuate dramatically from year to year, and there is a substantial (33%) chance of earning far less than the “expected return” of +100% each year.

Contrived Example #2: A particular investment loses precisely 10% of its value every single year. According to most people, this investment could hardly be called risk-free. But according to the official finance definition, it is risk-free: Its returns are perfectly predictable.

Real World Example

Of course, the idea of an investment with negative real returns every year isn’t hypothetical. It’s called cash.

In an inflationary environment, cash consistently loses value. Unfortunately, many investors significantly underestimate the long-term effects of inflation, so they see cash as “safe.”

And we in the finance community don’t do a darned thing to help. After all, cash earns a fairly predictable (negative) real return. So we confirm the public’s idea that cash is “no-risk.”

Of course, when the investing public hears the finance experts say that cash is “no-risk,” they assume that the experts are using the word “risk” the same way everybody else does. They think we’re telling them that cash doesn’t lose its value. Talk about a miscommunication!

Let’s at least be consistent.

To make matters worse, many people in the finance community switch back and forth between definitions–usually without giving any explicit indication of which definition they’re using.

This particular mistake is consistent through the world of personal finance blogs, and it even happens in many personal finance books. Charles Schwab seems to do it non-stop when he writes, and David Bach does it as well. It’s an easy mistake to make, but it’s a mistake nonetheless.

My suggestions

For investors: When you hear somebody say that something is either risky or safe, just be aware that they could mean either of two significantly different things. If you really want to understand what the person is saying, take the time to figure out which definition they’re using.

For those of us who are personal finance writers or financial advisers: Let’s keep in mind the fact that when we say something is risky (or safe), most people are going to assume we’re using the everyday definition. If we mean something else, let’s at least tell them!

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Comments

  1. Solution?
    Just use different words… -___-

    In an engr. standpoint the financial risk is 2nd+ moments (Variance, etc.) while the “rest of the word” risk = 1st moment (mean, EV that is negative)

    I think I had this issue w/ a friend. I was using reward in both negative and positive terms. I.e. reward = return, risk = probability.

    When we speak in such terms that are that important I think more exact language is needed…

  2. “Just use different words…”

    I agree. If only the finance community had chosen a word that wasn’t already taken…

  3. Simple idea overlooked at great cost by many. Fantastic post.

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