Investment risk is often defined as the chance that the actual return from an investment may differ from what is expected. At least thats how most investing textbooks define it.

Check the dictionary for risk and youll see the possibility of suffering harm or loss. Thats probably closer to how most of us think about risk.

But the problem is that both definitions really miss the mark on what matters about investment risk for individuals. What we care about most is whether or not were going to meet our goals.

Are we going to have enough to retire on the date we planned and for the income we need? Will there be enough money to pay for our kids college education? When we get down to it, thats all that really matters to us about investment risk. Will there be enough money to do what we planned?

The difficulty is that investment world doesnt define risk this way. In the investment world, something is considered risky if its return varies greatly from the average (its volatile). They call it standard deviation. High standard deviation means risky. Low standard deviation means not risky (or not as risky). But this is the wrong way to measure risk and heres why.

The Wrong Way

Lets say you go to your local stock broker s office. Youll probably be asked to fill out a risk tolerance questionnaire. You answer a few multiple choice questions, the broker punches it in the computer, and out pops the perfect portfolio for you based on your risk tolerance. The computer says you ought to invest in a 20% stock/80% bond portfolio because you have a low risk tolerance you dont like volatility.

So you start plopping in your $300/month for retirement everything you can afford at the moment. You go along until you hit 65, which is when you told your financial adviser youd like to retire.

But theres a problem when you want to hand in your resignation at work just before your retirement date. You dont have enough money! Because you used such a safe portfolio you never earned enough money on your investments to reach your retirement goals.

I dont care how safe the portfolio is if you cant reach your goals by using it, then its RISKY . Do you really want to use a safe portfolio if its not going to get you to your goal? I didnt think so.

How to Really Measure Risk

If you want to measure the investment risk of a portfolio in a way that matters, you need to look at how likely it is youll meet your goal with that particular portfolio. A good financial planner will help you do this by looking at the historical return and risk of the portfolio along with other information. Then theyll use Monte Carlo simulations to estimate your chances of success.

This isnt a perfect method and a perfect method doesnt exist. Essentially, were trying to predict the future and thats ultimately impossible. However, its an improvement over assuming a steady rate of return and its better than just a shot in the dark. The key is to revisit this estimation every few years to see if youre on track and to adjust accordingly.

By assessing investment risk this way, you can make sure you invest in a portfolio that will provide a high enough return to meet your goals. It will help you avoid the scenario I described above because it doesnt just look at your risk tolerance. It also considers your required investment return to achieve your goals.

But this method also has the additional advantage of helping you avoid taking on more risk than necessary for your situation. Look at it this way. If you can meet your goals with a medium risk portfolio allocation. then why use a high risk portfolio? You dont need that additional risk, so you can choose to avoid it.

Now some people especially after the most recent stock market turmoil dont want to increase their investment risk even if it means they wont reach their goals. I think thats missing the forest for the trees, but you do have some options if you dont want to increase your investment risk. Be sure to check in later this month when I write about what to do if you dont want that increased risk!

Your Thoughts

How do you think about risk? Are you missing the point? Am I missing the point? Let me know what you think in the comments below!

Comments

Evan says

I actually think the right way is probably in the middle if I am putting $350 and making myself sick watching it go up and down because it is a volitile portfolio I doubt that would be a good option.

Paul Williams says

Evan, I see your point, but if you invest in a way that doesnt meet your goals (i.e. you cant retire as/when you wanted) then can it still qualify as the right way? I just think we need to be careful about mixing emotions and investing.

Alan Reed says

I think emotions are part of investing. If you cant sleep at night I dont think you are meeting or acknowledging a complete set of goals. As with everything, balance is the key to success. There are many considerations that go into risk. I think the key elements are: time, knowledge, diversity and a good feeling about the plan. My final point is to emphasize knowledge; after all it is your money.

Paul Williams says

Alan, I agree that balance is the key. Thats what Im getting at if you follow the conclusion there are alternatives if you dont want to increase your risk. So if you cant sleep at night because your goals require you to use a riskier portfolio than youre comfortable with then youll need to adjust your goals downward so you dont need as much risk.

Craig, I saw a comment come in my email earlier from Kevin at Christian Simplicity. Do you know what happened to it? I wanted to respond but your site was down then.

Craig says