January 27, 2009
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This introductory article is intended for the educated layman. It bypasses consideration of certain kinds of risk, such as liquidity risk, default risk, and systematic risk.
If hopes were dupes, fears may be liars.
—Clough
We are in a dark wood, and the way is not straight. The way of investing never is. But try to put out of your mind, for the next few minutes, the present dismaying state of the economy and your personal finances. My subject is the meaning of risk in the context of investing. All concepts and ideas have a history of genesis and development, and just so do our ideas concerning risk; the ideas themselves ought nonetheless to be timeless. The concept of risk, as an abstraction, should not depend upon the level or direction of the stock market.
Let’s first consider a risk that isn’t related to investing. If you have read Bill Bryson’s 1998 book, A Walk in the Woods, his account of hiking the Appalachian Trail, you will remember that at the outset, he dreads encounters with bears. At one point, he reassures himself with the historical fact that no one has been killed by a bear in New Hampshire or Vermont since 1784. A few pages later, though, his confidence evaporates, and he asks, “And how foolish must one be to be reassured by the information that no bear has killed a human in Vermont or New Hampshire in 200 years? That’s not because the bears have signed a treaty, you know.” Please pardon the metaphor, but that last remark is an important theme of this essay. Where there is uncertainty, there is risk. And there is uncertainty in finance because the bears have not signed a treaty.1
Risk as the Possibility of Loss
Long before the rise of modern financial theory, investors were well aware that their investments were at risk of losing value. In the middle of the last century, Benjamin Graham, the father of securities analysis, put forth the concept of “margin of safety,” which he described as “the secret of sound investment.” I will oversimplify his definition, but for a stock, it represents the earning power of the company that issued the stock, regardless of the stock’s price. That is to say, the margin of safety is a measure of reassurance that, should the stock’s price fall very low, it would continue to be worth something because of its stream of future earnings. According to Graham, you want to purchase investments with large margins of safety. But though he quantified the margin of safety, he did not quantify risk, which he defined as the possibility of the loss of value realized at the time of sale of an asset.
With the rise of modern financial theory, financial risk has come to have many definitions, not necessarily because analysts have philosophical disagreements—though they do, and I will mention them—but because we now recognize many kinds of risk. Nearly all are or can be expressed in the form of a probability or chance of loss. The risk that is most pertinent to an individual investor, I believe, is the possibility of not having the expected amount of money when that money is needed, a definition that is close to Graham’s. Retirement accounts offer an especially stark illustration: If a couple requires and expects, say, a nest egg of $3,000,000 for retirement at age 67 in order to live out the remainder of their lives in the manner they choose, then they are at risk to the extent that there is a possibility that they will have less than that amount. But there is also risk in the case of the couple who wish to pay for a private school for their child out of their savings. One should not impertinently dismiss the latter as a luxury while considering the former a necessity. The latter couple may have concluded that their child was more likely to flourish in the private school than in a public one, and the former couple would be aiming to live at a level of comfort that is unknown to many poorer retirees. And perhaps it is the same couple that has both goals; that is, a single person or family may face multiple risks and have to face tradeoffs. Both plans are subject to risk. An investment advisor can help clients work through the problem of addressing these goals.
But this definition of risk, though reasonable, is not very practical by itself. How would I estimate the chances of having insufficient funds to pay for these requirements? And what is the relevance of this definition when we talk about the risk of a single stock, or the risk of the stock market? My holding of, say, Ford stock or Citigroup stock does not all by itself carry the risk that I won’t at some point in the future have the funds to pay for my retirement. That’s because I hold other investments as well, which may be able to pay for my plans.
1 As of this writing, the statement about Vermont and New Hampshire is still true. In 2000, however, a hiker in the Great Smoky Mountains was killed by a mother black bear and her cub.
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