Most investors, (and many advisors too), think of investment risk as something that can be precisely measured. I disagree. Some segments of risk can be quantified based on market history, but the entire spectrum of risk cannot be accurately measured because by its very definition risk is something that’s invisible. Of course, even so, many financial advisors earnestly try to put numerical values on risk because it satisfies the quest for certainty that both investors and advisors carry around.
Because financial risk can’t be seen, it also can’t be precisely engineered. Sure, certain possibilities and probabilities can be modeled but that still doesn’t adequately describe risk. In reality, financial risk (and investment risk more narrowly) can’t be fully prepared for in advance. You can’t totally eliminate risk no matter what you do.
How Would You Describe Risk?
A large part of the problem with assessing investment risk can be traced back to how risk is described. Most investors believe risk is what they experienced (and want to avoid going through again) during 2007-2009. The broad stock market declined by more than 54% between October 2007 and March 2009. This was extreme volatility for sure, but nonetheless did not represent a watershed event for the stock market. From the March 9, 2009 market bottom of 676, the S&P 500 has risen to over 3300 at this writing for an increase of almost 500%. The primary aim for investors is to maintain purchasing power including the impact of inflation. The ability to build and sustain your lifestyle is the true essence of money. Anything that enhances that ability over time is less risky than something that doesn’t provide that ability.
Therefore, using the past decade as a guide, being invested in the stock market was substantially less risky than not being in the market. Because we can’t see risk, we can’t know exactly when the periods of insecurity or discomfort will arise. From a financial planning viewpoint, it seems much more acceptable to experience some discomfort during your working life when you have greater flexibility than after you have retired when your options are more limited. The discomfort of a declining lifestyle in retirement far outweighs the insecurity from continuing to invest while in a period of temporary market decline (like 2007-2009).
Measurements of investment risk all occur after risky events, not before. If you change the way you define risk, your whole perspective will change. Start there.
Related: The Real Financial Planning Pyramid