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Alternative Definitions of Risk

By Morgan Housel - May 6, 2016 at 11:31AM

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Threats lurking where you're not looking.

The Dow closed at 12,810 on April 29, 2011, and 10,655 on October 2, 2011. Two trillion dollars disappeared in five months – poof.

There's a standard name for this: Risk.

Risk is when assets you own move in a direction you'd prefer they don't. It's typically measured by volatility, which the summer of 2011 was full of.

That's what we've been taught, at least. 

But during this flood of risk, the most common investor response was a shoulder shrug.

At peak volatility in August 2011, just 2% of Vanguard investors made a change to their portfolios. "Ninety-eight percent took no action," wrote Steve Utkus of Vanguard. "Those trading are a very small subset of investors."

If you polled investors today, my bet is two-thirds don't remember the summer of 2011. Most of the rest remember but don't care.

So, was the summer of 2011 risky?

For some investors, yeah. For most, probably not. It had no lasting impact. Which goes to show that "risk" is harder to define than we're often taught.

My definition of investing risk is the chance that you won't be able to do something in the future that you will want to do in the future. It can be caused by dozens of factors, the least of which is current volatility.

Consider:

The risk of changing goals

Three psychologists once wrote a paper about a phenomenon they called the "end of history illusion." In short, we know our values changed considerably in the past, but we tend to think that now, today, we've got life figured out and won't change in the future.

"People have a fundamental misconception about their future selves," they wrote. "Time is a powerful force that transforms people's preferences, reshapes their values, and alters their personalities."

This affects how we invest, because investing requires making decisions today for ourselves tomorrow -- even though we don't know who we'll be tomorrow.  

Those who rebelled against wealth and capitalism in the 1970s are some of the same people who now regret not saving enough for retirement. Millennials I know tend to come in two groups: One values travel and experiences, the other wants to work as hard as possible to earn and save as much as possible. I suspect many of both groups will find regret in due time. One will wish they saved more, the other will wish they lived a fuller life while they could. 

The risk of inadequate return

Cash is now the most desirable asset among savers age 18 to 29,  even if the money isn't needed for 10 years, according to a survey by Bankrate.

Young investors do this to cut down on the risk of investing in stocks. But odds are they will come to see this as one of the riskiest investments they ever make. Cash for the long-term won't fund future goals, while the market volatility they're avoiding today posed little risk to those future goals.

The risk of new laws

Social Security benefits were tax-free until they weren't. Student loans could be discharged in bankruptcy until they couldn't. Credit-card interest was tax-deductible until it wasn't.

Laws change in ways no one can foresee. The risk is that you're counting on a law today that won't be there tomorrow when you need it.

One risk is that Roth IRA gains could be taxed in the future. Income tax rates could rise so much that 401(k) assets are worth considerably less than you once assumed.

Those aren't predictions, but the odds are low that today's tax, legal, and regulatory investing rules will look the same 20 or 30 years from now. For most investors that's a much larger investing risk than, say, what the market does next month.  

The risk of new discoveries and old truths debunked

According to science writer Sam Arbesman, half of all facts about cirrhosis and hepatitis have been disproven or updated in the last 50 years. One-third of all species declared extinct have been rediscovered.

If the rigors of hard science commonly debunk what they once thought were truths, imagine what can happen in the soft, mood-driven world of investing.

Stock dividends used to consistently yield more than bonds. The Dogs of the Dow was an easy way to outperform. Sell-in-May-and-go-away was once a legitimate strategy. Hedge funds used to consistently outperform index funds.

None of these are true anymore, either because the world changed or we realized we were overlooking other factors.

At every point in history we can find something we believed 20 years ago that isn't true anymore. I don't know what will change or be disproven over the next 20 years, but I suspect it will be around indexing and passive investing, a strategy we currently take as unbreakable gospel. It will require a shift and adaptation, which many will fight, which is quite a risk. 

The risk of your own behavior and ignorance

This is the big one. Markets don't produce risk. They just do their thing while people who don't understand the destruction of their own behavior put themselves in risky situations.

Selling in the summer of 2011 -- or 2008, or 2002, or 1987 -- was self-inflicted risk. The market decline wasn't the problem; the decision to react to the decline by selling was the real risk.

Successful investing requires a religious faith to two things: One, stocks are meant to be long-term investments. Two, volatility is real, common, and normal. Respecting both puts you at the highest odds of being a happy investor over time. Forgetting it, ignoring it, and acting against it is the single biggest risk you face as an investor.

For more: 

Performance vs. outcomes

Why does pessimism sound so smart?

Things I'm pretty sure about

Hard truths for investors to wrap their heads around

How the investing industry could change  

Contact Morgan Housel at mhousel@fool.com. The Motley Fool has a disclosure policy.

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