What is Risk?
Risk can be a confusing concept. You may have the following kinds of definitions in mind:
- Probability of decline in your assets’ values
- Volatility of your assets
How about the concept of uncertainty of effect on lifetime consumption? Lifetime consumption includes all your anticipated and intended expenditures, including gifts, political and charitable contributions, plus all the everyday expenses like food, insurance, and taxes.
So, using this definition, anything that adversely affects your ability to complete your concept of lifetime consumption would be risky.
For many of the things that can adversely affect this ability you can buy insurance. For example, life insurance, auto insurance, home insurance, liability insurance, etc. While these all cost money, and you hope to never have to use these policies, if the insured risks do occur, their occurrence will not adversely affect your financial well-being.
Now, let us think about investing. Should you invest in a company or market that you do not understand completely is an increase in your risk, as defined above. Incomplete understanding can be very pervasive.
Consider those employees of Enron. Many of those Enron employees thought they knew the company. They had their entire savings as well as their jobs (income source) invested in Enron. When the company went bankrupt, the employees lost their income, wealth, and retirement savings.
Your own lifetime consumption might be the best yardstick to measure an investment’s risk and uncertainty. That yardstick, when applied, may enable you to avoid risks you should not take.