What risk actually means in investing

Risk in finance is usually measured as volatility because volatility is measurable, which is not the same as it being the thing that matters.

The standard definition

Volatility: the dispersion of returns around their average, generally expressed as standard deviation.

It is convenient, computable and comparable.

Its limitations: it treats upside and downside movement identically; it assumes a distribution of returns that understates the frequency of extreme events; and it says nothing about whether the outcome you need will be achieved.

The risks that actually matter

To an individual investor.

Shortfall risk: not having enough money when you need it, which is the risk the whole exercise exists to manage.

A portfolio that is too cautious carries substantial shortfall risk while displaying low volatility, which is why volatility alone is a poor guide.

Permanent loss of capital, as distinct from temporary decline — from a company failing, from a fraud, or from selling at the bottom.

Sequence risk: the order in which returns arrive, which matters enormously when withdrawing and not at all when accumulating without withdrawals.

Inflation risk: the erosion of purchasing power, which is the risk that cash carries and which is invisible because the balance does not fall.

Behavioural risk: the risk that you will do something damaging, which the evidence suggests is the largest risk for many investors.

And concentration risk, from holding too much in one thing — including an employer's shares alongside employment with them.

Drawdowns

What actually happens.

Equity markets have historically experienced declines of substantial magnitude periodically, including falls of a third or more.

Recovery times have varied from months to many years.

These are normal features rather than aberrations, and any long-term investor should expect to experience several.

Which means the relevant planning question is not whether a large fall will happen but what you will do when it does.

Looking at historical drawdowns for a proposed allocation, and asking honestly whether you would have held on, is more useful than any risk questionnaire.

Capacity versus tolerance

Two distinct concepts.

Capacity for loss: what would actually happen to your circumstances if the portfolio fell substantially — whether you would have to change your plans, delay retirement or reduce spending.

Tolerance for volatility: how you would feel and behave.

These can differ: someone with high capacity and low tolerance will sell at the wrong moment, and someone with low capacity and high tolerance may take risks their circumstances cannot absorb.

The binding constraint is whichever is lower.

Risk questionnaires

Their limits.

They are generally administered when markets are calm, and answers given then predict behaviour during stress poorly.

They frequently conflate capacity and tolerance.

They produce a category rather than a plan.

Which does not make them worthless — they open a conversation — and which means the more useful exercise is expressing risk in money: what a given fall would mean in the actual amount you would see on the statement.

People respond quite differently to a percentage and to a figure.

Diversification

The main tool.

Holding assets that do not move together reduces the volatility of the whole without proportionally reducing expected return, which is as close to a free benefit as investing offers.

Its limitation: correlations tend to rise during severe stress, meaning diversification works least well at exactly the moment it is most wanted.

Which is an argument for holding genuinely different asset types rather than many variations of the same exposure.

And for holding some cash, which is the only asset that reliably does not fall in nominal terms.

Risk that cannot be diversified away

Worth understanding.

Specific risk — the risk attached to one company — can be diversified away by holding many.

Market risk cannot, since it affects everything.

Which is the theoretical justification for broad diversification: it removes the risk you are not compensated for taking, and leaves the risk you are.

Holding a small number of individual shares therefore involves taking risk without a corresponding expected reward, which is the strongest argument against concentrated retail portfolios.

The practical approach

What follows.

Define what the money is for and when it is needed, which determines the horizon.

Set an allocation you could hold through a substantial fall.

Diversify broadly.

Keep short-term money in cash.

Write down in advance what you will do in a fall, which is the single most useful protection against behavioural risk.

And review the plan on a schedule rather than in response to markets.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.