I think that defining what risk is is the most difficult topic in finance/investing.
I’m not sure there’s one answer that fits everyone and everything.
We do know that individuals’ perception of what risk entails changes as they age or as their wealth increases; they become more conservative. We also know that appearances can be deceiving. A model with a perfectly proportioned body may be clumsy or a terrible athlete. Experience counts for something, as well. Situations that appear risky when a neophyte is in control, like in doing brain surgery, may in fact be relatively safe in the hands of an expert. Information is important, too, like having enough data or experience to know who is the beginner and who is the well-trained seasoned pro.
risk as volatility
Academic finance, and following its lead, pension consultants and their pension fund clients, have all chosen to reduce this complexity to a single concept, risk = volatility. In other words, the magnitude of day to day price changes in securities. This can be expressed either in absolute form or relative to some benchmark, and may be measured over differing time periods.
Defining risk as volatility has three big advantages:
–easy data availability
In a world where no one runs with scissors or texts while driving, or where there’s never a flood, a tornado or huge food items falling from the sky (like in Chewandswallow), that would be enough.
In practice, however, volatility isn’t such a hot measure.
On a very abstract level, there’s no recognition of the issue that philosophers have been pondering for the past two centuries or so–that groups may not be connected by every member having a single thing in common. One alternative is the possibility of “family resemblances” popularized by Ludwig Wittgenstein over a half-century ago. So maybe there isn’t one common factor that constitutes risk.
On a more practical level, in the real world not everyone has the same information. History also shows that markets periodically become highly emotional, either wildly optimistic or deeply pessimistic. My conclusion, based on decades of experience, is that the results of daily trading don’t constitute infallible indicators. Quite the opposite–most often one should take the evidence of daily trading with a grain of salt.
…but does it trade?
To my mind, though, the most striking failure of volatility as a risk measure is that it doesn’t take liquidity into account.
An example of what I mean:
In the mid 1980s, I came across for the first time academic articles that touted real estate as the most attractive of major asset classes.
The argument was that since the end of WWII real estate had not only a higher annual rate of return than stocks or bonds, but it also had the lowest average price volatility of the three. Not only did real estate deliver the highest absolute gains, but adjusting for its low “risk” property ownership looked even better. This was an odd result, because one typically thinks that reward and risk are directly correlated, not inversely. But no one questioned it.
Anyone who has owned a home over an extended period of time, to say nothing of owners of commercial or office real estate, knows this is loony. In bad times, bank finance disappears and, along with this, so too transactions. During 1981-83 in the US, when I experienced this phenomenon first-hand, houses could only be sold at extremely steep discounts to pre-recession prices–or to owners’ notions of fair value based on rental equivalents. Potential buyers made very low-ball offers, prospective sellers took their homes off the market, and no transactions happened. In the very narrow sense, therefore, volatility was low. But that was because there were no sales to demonstrate how the market had deteriorated, prices were stable. You just couldn’t sell.
The collapse of the junk bond market in the late 1980s demonstrated the same idea. Junk bonds had been touted as having “all the rewards of stocks with all of the safety of bonds.” The safety part proved an illusion. The apparent stability of the net asset values of junk bond funds ended up resting in large part on the fact that the bonds they held seldom traded. So every day the funds priced themselves using more or less the last trade, which might have been weeks ago–and which might not reflect current circumstances. This idyll lasted until funds began to have net redemptions, forcing them to sell bonds at real market prices, which were often way below their carrying value on fund books.