Risk in 90 Seconds
The investor needs a good grasp of risk if he/she expects to succeed. Although uncertainty is not a perfect definition of risk, if one accepts uncertainty as a reasonable definition of risk it will take one most of the way toward the objective of both understanding and quantifying risk.
Risk = Uncertainty
(not perfect, but a good start)
- Although market prices move randomly, one can calculate volatility, which equates to something known as standard deviation. This leads to:
Volatility <=> Uncertainty <=> Risk <=> Uncertainty <=> Volatility
- By altering the ingredients of a portfolio, one can change its volatility. Thus, one can design a portfolio to a desired level of volatility/uncertainty/risk.
- Of course, risk and return are linked at the hip, so if the investor wants additional return, he/she will likely have to accommodate additional risk.
|Risk & Return from 1975-2014
One Year Time Period for a $100,000 Investment
|Investment||Risk||95% Probability Range of $100,00 for 1 year||Average End Point|
|US Small Stocks||Very High||$68,800||$146,800||$115,600|
|US Long Term Bonds||Medium||$87,800||$120,800||$108,600|
|US Short Term Govt Bonds||Low||$90,100||$116,600||$106,700|
NOTE: Past performance does not indicate future performance.
As you can see, risk and return are related. Per the table:
Higher Risk ⇒ Greater Uncertainty Range ⇒ Higher Average Return
But again, this is only for the 1975-2014 investment period, and past performance does not predict future performance. Also, in any given year one of the above will outperform the others. It often takes many years for the risk and return trade-off to run its course.
Starting with a golf example before moving on to investments, Chapter 3 of Great Minds. Great Wealth. Great for Your 401k. makes the topic of Risk fun, engaging, understandable and highly applicable, not only to investing but to many other areas of business and life.