In investing, your definition of risk has a major impact on how you should invest. Not knowing your definition could lead to uncomfortable asset allocations that leave you awake at night or situations where you panic and sell at the lows.
In financial services, the common definition of risk is actually the definition of “portfolio drawdown”. Portfolio drawdown is the amount your portfolio value decreases from its recent high to its current low. A diagram may explain it better:
Why does the financial services industry use this definition? Most investors anchor to the recent high value in their portfolio. Even though they are just paper profits, people see that value as their new account value and imagine it going higher. But what if it doesn’t? Well that’s when clients call their advisors and start asking about getting out of the market. By reducing “risk” (portfolio drawdown), advisors are more likely to keep their investors in the market. By keeping their investors in the market, they can continue to charge fees and promote the buy and hold system.
I like to use another definition of risk. I define risk as “What will the other guy do?”
Think about it. Things you are in control of aren’t risky. It’s the outside world, usually humans, that are risky. If I am walking along a street and come to an intersection, the risk of being hit by a car comes from the other guy, not me. I am certain I will wait on the sidewalk until the walk signal comes on, look both ways and cross to the other side before the do not walk light comes on. The risk of injury to me comes from a driver who doesn’t stop for their red light. It’s the other guy. Their actions are what I define as “risk”.
One of the trading ideas I had early on when learning to trade was to buy stocks that were likely to have good quarterly earnings before their earnings were released. Often times however, the company would report good earnings results, but the stock would drop. Most likely a large investor such as a mutual fund decided to sell. I say large investor because it has to be someone with a significantly large sell order to cause the price to drop.
If we expand this idea of risk to the overall market, “risk” is what the other investors in the market will do at any given time. Risk is all the other people including fund managers that start selling. It doesn’t matter why they start selling, but the fact that they could do brings risk. The other guys are not predictable. They are your risk. They are the market risk. They define “risk”.