Risk is absolutely fundamental to investing; no discussion of returns or performance is meaningful without at least some mention of the risk involved. The trouble for new investors, though, is figuring out just where risk really lies and what the differences are between low risk and high risk.
SEE: What Is Your Risk Tolerance?
What Is Risk?
Given how fundamental risk is to investments, many new investors assume that it is a well-defined and quantifiable idea. Unfortunately, it is not. Bizarre as it may sound, there is still no real agreement on what "risk" means or how it should be measured.
Academics have often tried to use volatility as a proxy for risk. To a certain extent, this makes perfect sense. Volatility is a measure of how much a given number can vary over time and the wider the range of possibilities, the more likely some of those possibilities will be bad. Better yet, volatility is relatively easy to measure.
Unfortunately, volatility is flawed as a measure of risk. While it is true that a more volatile stock or bond exposes the owner to a wider range of possible outcomes, it doesn't necessarily impact the likelihood of those outcomes. In many respects, volatility is more like the turbulence a passenger experiences on an airplane – unpleasant, perhaps, but not really bearing much relationship to the likelihood of a crash.
A better way to think of risk is as the possibility or probability of an asset experiencing a permanent loss of value or below-expectation performance. If an investor buys an asset expecting a 10% return, the likelihood that the return will be below 10% is the risk of that investment. What this also means is that underperformance relative to an index is not necessarily risk - if an investor buys an asset with the expectation that it will return 7% and it returns 8%, the fact that the S&P 500 returned 10% is largely irrelevant.
What Is a Low or High-Risk Investment?
If investors accept the notion that investment risk is defined by a loss of capital and/or underperformance relative to expectations, it makes defining low risk and high-risk investments substantially easier.
A high-risk investment is one where there is either a large percentage chance of loss of capital or underperformance, or a relatively small chance of a devastating loss. The first of these is intuitive, if subjective - if you were told there's a 50/50 chance that your investment will earn your expected return, you may find that quite risky. If you were told that there is a 95% chance that the investment will not earn your expected return, almost everybody will agree that that is risky.
The second half, though, is the one that many investors neglect to consider. To illustrate it, take for example car and airplane crashes. The odds of any driver experiencing a car crash in their lifetime is quite high (25%), but the odds of death are relatively low (less than 1%). By comparison, the odds of experiencing a plane crash are quite low (one-hundredth of 1%), but the odds of dying in a plane crash are quite high (about 67%).
What this means for investors is that they must consider both the likelihood and the magnitude of bad outcomes. Low-risk investing not only means protecting against the chance of any loss, but it also means making sure that none of the potential losses will be devastating.
A Few Examples
Let us consider a few examples to further illustrate the difference between high risk and low-risk investments.
Biotechnology stocks are notoriously risky. Between 85 and 90% of all new experimental drugs will fail, and not surprisingly most biotech stocks will also, eventually, fail. In the case of biotech stocks, there is both a high percentage chance of underperformance (most will fail), AND a large amount of potential underperformance (when biotech stocks fail, they usually lose 95% or more of their value).
In comparison, a United States Treasury bond offers a very different risk profile. There is almost no chance that an investor holding a Treasury bond will fail to receive the stated interest and principal payments, and even if there were delays in payment (extremely rare in the history of the U.S.), investors would likely recoup a large portion of the investment.
It is also important to consider the impact that diversification can have on the risk of an investment portfolio. Generally speaking, the dividend-paying stocks of major Fortune 100 corporations are quite safe, and investors can expected to earn mid-to-high single-digit returns over the course of many years.
That said, there is always a risk that an individual company will fail; companies like Eastman Kodak and Woolworth's are famous examples of one-time success stories that eventually failed. What's more, a randomly chosen stock held for a decade has about a 20% chance of losing money. If an investor holds all of their money in one stock, the odds of a bad event happening may still be relatively low, but the potential severity is quite high. Hold a portfolio of 10 such stocks, though, and not only does the risk of portfolio underperformance decline, but so too does the magnitude of the potential overall portfolio decline.
A Few More Thoughts on Risk
Investors need to be willing to look at risk in comprehensive and flexible ways. For instance, diversification is an important part of risk. Holding a portfolio of investments that all have low risk, but all have the same risk, can be quite dangerous. Going back to the airplane example, the odds of an individual plane crashing are low, but virtually every large airline has (or will) experience a crash. Holding a portfolio of low-risk Treasury bonds may seem like very low-risk investing, but they all share the same risks and the occurrence of a very low probability event (like a U.S. government default) would be devastating.
Investors also have to include factors like time horizon, expected returns and knowledge when thinking about risk. On the whole, the longer an investor can wait for their returns, the more likely they are to achieve their expected returns. There is certainly some correlation between risk and return, and investors expecting huge returns are going to have to accept a much larger risk of underperformance. Knowledge is also important, not only in identifying those investments most likely to achieve their expected return (or better), but also in correctly identifying the likelihood and magnitude of what can go wrong.
The Bottom Line
There are no perfect definitions or measurements of risk, but inexperienced investors would do well to think of risk in terms of the odds that a given investment (or portfolio of investments) will fail to achieve the expected return, and the magnitude by which it will miss that target. By better understanding what risk is, and where it can come from, investors can work to build portfolios that not only have a lower probability of loss, but a lower maximum potential loss as well.