What is Risk, Anyway?


Anytime someone claims to outperform the market, others are quick offer the default response... "You know, on a risk-adjustedbasis, you didn't really outperform.  You took more risk, so you enjoyed greater reward."

The problem with that response is it suggests more risk guarantees more reward.  It ignores the fact that risk truly means we have no idea what will happen next.  The only thing risk guarantees is that uneasy feeling of not knowing whether a company's stock will plummet, skyrocket, or do anything in between.

I can see how people could fall into believing that "risk equals reward," especially in this bull market we've been riding since 2009.  Many investors who bought popular (and risky) technology stocks years ago are enjoying incredible returns on their investment.  In these quite common cases, it just so happens that greater risk translated into greater reward.  

But that's not how the stock market always works.  On average, the S&P 500 will rise every two out of three years.  Eventually, we all know that stocks will fall, and the market will end the year lower than where it started.  Some companies will fare better than others.  Right now, at this moment, it's impossible to predict when this will happen, and it's even more difficult to know how one company will perform.  

In any moment, looking toward the future, every investment carries risk.  Even more importantly, you can't guarantee outperformance by simply being "riskier."

My favorite definition of risk comes from The Devil's Financial Dictionary by Jason Zweig.  He broadly defines risk as "the gap between what investors think they know and what they end up learning."  I love this definition.  The fact is, no matter how strongly we believe in a company or strategy, markets change, and what works now might not work a year from now.

For long-term investors, the one thing that doesn't change is the race against the S&P 500.  After all, we know that it's so easy to buy ETF's and index funds that guarantee market-matching results.  And we also know that over the very long term, the S&P 500 is almost certainly guaranteed to rise.  

So, if you can pick stocks and build a portfolio that actually beats the S&P 500 over a period of at least a year, that's something to be proud of.  And if you can do that in good times and bad, that's even more impressive.  This performance cannot be credited to the simple fact that you took more risk; you and your decisions are the reason for your success.



Disclosure: This blog represents my personal opinions.  I am not a financial advisor.  Do not buy or sell securities based solely on what you read on this website.  Seek opinions from a qualified financial professional before making any financial decisions.  See the Terms of Service for more details.