What Risk Isn’t

Nick Maggiulli asks the investors what is the risk? Wikipedia defines it as “the possibility of something bad happening.” In the investment industry, we commonly associate risk with standard deviation, or how often an investment’s return varies from its average return.  More simply, if investment A has annual returns of +4%, +4%, +4% and investment B has annual returns of +4%, -9%, +19%, then investment B would be deemed “riskier” than investment A despite having the same long-term growth rate. But is the standard deviation the best definition of investment risk?  Not necessarily.

For any prudent investor, the difference between volatility and risk comes down to what is known versus what is unknown.  As Donald Rumsfeld once said: There are known knowns; things we know we know. There are known unknowns; things we know we do not know. But there are also unknown unknowns — things we don’t know we don’t know.

Volatility is a known unknown, while the risk is an unknown unknown. Volatility is a known unknown because though we cannot predict future volatility, we can make reasonable guesses about its future range. This is why Maggiulli doesn’t equate risk with volatility.  People will say that an investment is “too risky” for them, but what they usually mean is that it is too volatile.  Some investors prefer the predictability of bond income while others want the thrill of individual stocks, options, and leverage.  This isn’t about risk, but about the kind of expected returns, an individual investor prefers.

But, the risk is another beast entirely.  Because risk is about the things that happen that can’t be expected.  As Josh Wolfe has preached many times: Failure comes from a failure to imagine failure. That’s where risk lives. Maggiulli says that 2020 has made him realize that black swans (an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences) are the only kind of risk that matters.  Why?  Because they are the only kind of risk that can’t be prepared for, and, thus, the only kind of risk that can cause catastrophic loss.

Maggiulli asks so how do you prepare for something that can’t be prepared for?  You try the best you can.  Do scenario planning.  Have ample liquid savings.  Search for flaws in your investment hypotheses.  If you spend time to think about what is possible, then you might just be able to save yourself from some of these black swans. Yes, there will always be future scenarios that you can’t conceptualize or account for initially.  But, where is the harm in trying?  Because risk isn’t the possibility of something bad happening.  Risk is the possibility of something bad happening that you didn’t plan for.