Understanding Risk

Defining investment risk us as nebulous as defining time. We can get our minds around the basic concept but have trouble communicating what we mean.

For one person defining themselves as being a conservative investor may mean that they invest their money in cash and cash equivalents. Another investor it may mean burying money under the front porch in an old mayonnaise jar. Still another it could be to invest in equities that have significant less risk than the market. When attempting to communicate exactly what they mean by their definition of being a conservative investor to their stockbroker or financial planner the differences in risk and volatility can be significant even though they all use the same word it means something different to each of them.

To define the amount of risk an investor is comfortable assuming there are helpful methods that money management firms have designed. The most common are professionally designed risk questionnaires. The problem is that investors have to answer the questions, and that involves individual subjectivity.

And it's that subjectivity defining their investment risk is what gets investors and their planners in trouble. People with conservative tendencies have told me that their planner thinks that they should be investing in an S&P 500 mutual fund and that will achieve their goals in actual return and in relative emotional comfort. That's planner subjectivity, or ignorance, and is a time bomb waiting to explode.

To clarify what we mean the entire process of understanding risk to return can be dealt with by simply asking, 'How much return on investment am I happy making on a consistent basis and how much am I willing to lose if the markets suddenly go south?'

It should be that simple. And if more people did just that we would have a lot less problems, arbitrators and lawyers clogging up valuable investment management space and time.

Here's what you do - write your goals on a 3x5 card and tape it somewhere where you can see it everyday to remind yourself what you want to earn consistently on your investments and what price you're willing to pay when things go wrong. Stick with your written goals no matter what, during good times and especially bad. And, in case you still don't get it, things will go terribly wrong many times in your investment lifetime no matter how many rules and regulations the government creates and enforces.