Simple Stuff: What is Risk?

May 16, 2016

5 minute read

Simple Stuff: What is Risk?

by David Merkel, Aleph Blog

This is another piece in the irregular Simple Stuff series, which is an attempt to make complex topics simple. Today’s topic is:

What is risk?

Here is my simple definition of risk:

Risk is the probability that an entity will not meet its goals, and the degree of pain it will go through depending on how much it missed the goals.

There are several good things about this definition:

Note that the word “money” is not mentioned. As such, it can cover a wide number of situations.
It is individual. The same size of a miss of a goal for one person may cause him to go broke, while another just has to miss a vacation. The same event may happen for two people — it may be a miss for one, and not for the other one.
It catches both aspects of risk — likelihood of a bad event, and degree of harm from how badly the goal was missed.
It takes into account the possibility that there are many goals that must be met.
It covers both composite entities like corporations, families, nations and cultures, as well as individuals.
It doesn’t make life easy for academic economists who want to have a uniform definition of risk so that they can publish economics and finance papers that are bogus. Erudite, but bogus.
It doesn’t specify that there has to be a single time horizon, or any time horizon.
It doesn’t specify a method for analysis. That should vary by the situation being analyzed.

But this is a blog on finance and investing risk, so now I will focus on that large class of situations.

What is Financial Risk?

Here are some things that financial risk can be:

You don’t get to retire when you want to, or, your retirement is not as nice as you might like
One or more of your children can’t go to college, or, can’t go to the college that the would like to attend
You can’t buy the home/auto/etc. of your choice.
A financial security plan, like a defined benefit plan, or Social Security has to cut back benefit payments.
The firm you work for goes broke, or gets competed into an also-ran.
You lose your job, can’t find another job as good, and you default on important regular bills as a result. The same applies to people who run their own business.
Levered financial businesses, like banks and shadow banks, make too many loans to marginal borrowers, and find at some point that their borrowers can’t pay them back, and at the same time, no one wants to lend to them. This can be harmful not just to the banks and shadow banks, but to the economy as a whole.

Let’s use retirement as an example of how to analyze financial risk. I have a series of articles that I have written on the topic based on the idea of the personal required investment earnings rate [PRIER]. PRIER is not a unique concept of mine, but is attempt to apply the ideas of professionals trying to manage the assets and liabilities of an endowment, defined benefit plan, or life insurance company to the needs of an individual or a family.

The main idea is to try to calculate the rate of return you will need over time to meet your eventual goals. From my prior “PRIER” article, which was written back in January 2008, prior to the financial crisis:

To the extent that one can estimate what one can reasonably save (hard, but worth doing), and what the needs of the future will cost, and when they will come due (harder, but worth doing), one can estimate personal contribution and required investment earnings rates. Set up a spreadsheet with current assets and the likely savings as positive figures, and the future needs as negative figures, with the likely dates next to them. Then use the XIRR function in Excel to estimate the personal required investment earnings rate [PRIER].

I’m treating financial planning in the same way that a Defined Benefit pension plan analyzes its risks. There’s a reason for this, and I’ll get to that later. Just as we know that a high assumed investment earnings rate at a defined benefit pension plan is a red flag, it is the same to an individual with a high PRIER.

Now, suppose at the end of the exercise one finds that the PRIER is greater than the yield on 10-year BBB bonds by more than 3%. (Today that would be higher than 9%.) That means you are not likely to make your goals. You can either:

Save more, or,

Reduce future expectations,whether that comes from doing the same things cheaper, or deferring when you do them.

Those are hard choices, but most people don’t make those choices because they never sit down and run the numbers. Now, I left out a common choice that is more commonly chosen: invest more aggressively. This is more commonly done because it is “free.” In order to get more return, one must take more risk, so take more risk and you will get more return, right? Right?!

Sadly, no. Go back to Defined Benefit programs for a moment. Think of the last eight years, where the average DB plan has been chasing a 8-9%/yr required yield. What have they earned? On a 60/40 equity/debt mandate, using the S&P 500 and the Lehman Aggregate as proxies, the return would be 3.5%/year, with the lion’s share coming from the less risky investment grade bonds. The overshoot of the ’90s has been replaced by the undershoot of the 2000s. Now, missing your funding target for eight years at 5%/yr or so is serious stuff, and this is a problem being faced by DB pension plans and individuals today.

The article goes on, and there are several others that flesh out the ideas further:

Simple Summary

Though there are complexities in trying to manage financial risk, the main ideas for dealing with financial risk are these:

Spend time estimating your future needs and what resources you can put toward them.
Be conservative in what you think you assets can earn.
Be flexible in your goals if you find that you cannot reasonably achieve your dreams.
Consider what can go wrong, get proper insurance where needed, and be judicious on taking on large fixed commitments to spend money in the future.

PS — Two final notes:

On the topic of “what can go wrong in personal finance, I did a series on that here.

Investment risk is sometimes confused with volatility. Here’s a discussion of when that makes sense, and when it doesn”t.