How Do You Define Investment Risk?

Each investor's definition and perception of risk will vary and be very personal. One person's sense of risk may be driven by market events. Another’s by lifetime experiences or memories. A third may have different views on risk based on their time horizon.

In this article, I introduce three categories of investment risk: volatility, benchmarks, and goals. I offer perspectives on each and share thoughts on why we feel one of these is the most impactful for many investors.

In the book, Against the Gods, economic historian Peter L. Bernstein provides an engaging exploration of risk in layperson's terms, suggesting that risk, and managing it, is at least partly about defining what may happen in the future and choosing among alternatives for a vast range of decisions, from allocating wealth to wearing a seatbelt.

I'll start in a simpler place. We probably think about investment risk as the risk of potential financial loss from decisions that may affect our portfolio. Volatility in the value of a portfolio is a place to start.

Volatility, broadly stated, is a change in price, up or down, over short or long periods of time of an investment, investments, or a portfolio. It's traditionally measured or projected hourly, daily, weekly, monthly, annually, or longer over whatever time you choose. Simply stated, volatility is the relative ups and downs of price.

Here are three related measures:

• Standard deviation. This is a statistical measure, widely showing how the price or value of an investment rose or fell from its mean over a selected period. It's the most common measure of risk used today, but I'd argue it’s incomplete. Why? One reason is because many investors don't worry about "upside" volatility, but an investment that has sudden, sharp jumps upward in price is a volatile investment.  
• Downside risk. This is the measure of potential, or historical, losses. We know from the field of behavioral finance that investors generally feel more pain from losses than pleasure from gains.
• Permanent loss. Volatility in the short term hardly matters, if the general direction, on average, of investments is upward. But what about permanent loss, either through an untimely sale of an investment or a permanent drop in price, even to $0?

Volatility, up and down, happens. It's part of investing, for the most part, at least in stocks and investments outside of cash or bonds. It's how you react to it that's important. Do you have the tolerance, and framing, to manage volatility when it matters?

How investors react to volatility is inherently emotional, and it often changes. How we feel and react one day may be very different than another day, if market performance changes. It isn’t math. It's emotion. And it requires self-reflection, which at times can be difficult. 

Generally, benchmarks are risk measured in comparison to something else. This can be a rough measure of the stock market as a whole (the S&P 500^®, for example), a single stock you pick with a return you imagine is a reasonable target, your perception of how you think the market is doing, or (at worst, because it’s not even a true benchmark) a feeling about how your "neighbor" or another "smart investor" is doing. When chosen well, benchmarks can be helpful. If chosen poorly, or if vaguely defined, they can be harmful.

Here are some common benchmarks:

• S&P 500. This is an index, or a general measure, of a basket of the 500 largest stocks in the U.S. market. It's a widely used benchmark against which many investors, commentators, and managers, per its definition, track the performance of 500 of the largest U.S. companies. It's helpful, but less so if you have a truly diversified portfolio that includes bonds, cash, international investments, or individual securities rather than a portfolio 100% invested in U.S. large-cap stocks.
• Blended benchmark. This is a benchmark created using an allocation to other benchmarks based on a target, or personalized mix of stocks, bonds, cash, and other investments. Using an appropriate blended benchmark (ideally based on a plan or working with a planner or advisor based on your tolerance for risk, desired return, and goals) tends to be far better than using a single area of the market or a single benchmark.
• An expert on television (or your neighbors). This isn't a benchmark. It's imagined. It can be what you think your neighbor or someone you saw on TV believes about the markets or investing (often without good evidence).

Benchmarks can be emotional also, depending on which ones you choose. There's a saying I heard once from an advisor: "If you have a diversified portfolio, there may be something in it each quarter you don’t like." In every quarterly statement, there may always be a laggard. But the combination of investments is called a "portfolio" for a reason. Different pieces play different roles. Some chip in, for different purposes, when others don't. 

While investment risk can be measured by volatility or benchmarks, we suggest it also can be measured by the risk of not achieving goals, such as retirement, the ability to pay for health care expenses, or growing assets so you can leave a legacy or buy that dream vacation home. A goal can be defined as how much money will you need, for what future expenses, when.

What is the importance of each of these goals to you, personally? How much risk are you taking, or willing to take, to achieve each goal? And are you on track to achieve them? This, we believe, is an evolved, personal measure of risk that adds to the usefulness of volatility and benchmarks.

In a holistic, wealth management framework, risk can be addressed with a question: "Am I on track to reach, and fund, my goals? Yes, or no?" This gets at the No. 1 challenge in wealth management, which is understanding what it is that an individual wants their portfolio to do. What are you trying to achieve? A natural response might be, "Make money. Pick the best investments. Beat the markets." This is natural, normal, and almost impossible. We all want to be, and often feel we are, "above average." The real task in holistic wealth management is to manage resources to achieve a goal with the lowest required, and appropriate, level of risk of hurting your finances as possible.

Here are a few ways to measure the risk of not achieving your goals:

• Probability of success. This is a metric commonly used in financial planning tools. It's not a one-time calculation. Rather, it rises and falls based on a variety of factors, including contributions or withdrawals from your portfolio and market performance. It’s an evolved measure of risk. Schwab consultants and advisors help create and then use probability of success metrics with investors at Schwab.
• Needs, wants, and wishes. Different goals may have different priorities. Financial plans can show the probability of success for needs, wants, and wishes. Investors with multiple goals can look at the risk–or probability–of meeting each goal, based on a plan that looks at performance of investments toward a target (the goal) over time. 

In the illustration, the needs, wants, and wishes represent personalized goals chosen by a hypothetical investor. Each goal includes projections of anticipated costs, money needed to fund the goal, timing, and other factors. The colors represent confidence zones that the goals will be achieved. In this example, the investor is aiming to stay on track to fund goals between 75% to 90% of their projected costs. This would keep the investor in the green confidence zone.

The purple zone is a projected confidence zone of funding goals below 75%, absent making any changes such as reducing spending or working longer if the goal is retirement, for example. The blue zone is a projected probability of funding goals over 90%, which is above the targeted confidence zone of 75% to 90%, and nonetheless may be appropriate for some goals, such as funding basic living expenses in retirement.

With a goal-based planning approach like this, the intent is not to achieve a 100% "score." Rather, the goal is to balance how much you save and invest to achieve goals, and the investment risk taken in your portfolio, with a confidence level of achieving your goals that feels comfortable to you. For some investors, it may be reasonable to have certain wishes, such as leaving a legacy, fall below 50%. It's a wish after all, not a necessity.

The ability to use investments to fund future or current goals is likely the most relevant investment risk for most of us. This requires self-reflection, prioritization, proper framing, and a plan. Then, measuring and testing risk involves running scenarios against those goals. Under various scenarios, including up or down markets, would the portfolio work? Would it still achieve, and fund, those goals? Without this knowledge, investors walk through an emotional minefield, almost in the dark, reacting based on their framing rather than with a disciplined assessment of risk and self-control.

There are different measures of risk. All can be helpful or important. For most investors, if you haven't already, consider adding to the risk toolkit–name and quantify goals, and then project the risk of not achieving them. By doing this, it may be easier to ignore distractions and focus less on markets and more on what you want your money to do for you.