Today we’re gonna talk about risk – how we define it in finance and the investment world and how most normal people define risk.
If you’ve ever talked to a financial advisor about risk, they’ve probably talked about standard deviation, which basically, is volatility. Meaning, how much the particular investment they’re talking about – a stock, a bond or mutual fund, for example – has moved over the last week, month or year or for however long it’s been around. And it’s measured against that investments own average – the risk of “loss” doesn’t really figure in the equation.
Now, if I were to ask you to define risk – you’d probably say something along the lines of “What are the chances I’ll lose my money”, right?
So, right off the bat, there’s a disconnect between how risk is measured – sometimes badly – in finance and how we’d define it and this distinction is important to keep in mind as an investor.
Now, all of this is designed to help us manage an uncertain and unknowable future – we look at an investment’s past in the hope that it’ll tell us what it’s going to do in the future.
Deep down inside, we all know that we can’t predict the future – no advisor, not me, Warren Buffet or anyone else can tell us how an investment will perform tomorrow, next week or next month and forget about next year.
The best we can do is to properly set our expectations to manage the uncertainty associated with the future and we can do this by taking a long-term view to investing – know that prices will fluctuate but your emotions don’t have to.
So, the next time you sit with your financial advisor and they begin to talk about the riskiness of an investment, ask questions on what that means exactly, so that you’ll be prepared to ride the high’s and low’s of its price movement.
If you have any questions, please add them in the comments below.