I first learned about risk from the collected works of Stephen King. “Risk” hid in the closet. It lurked beneath my bed. If I pulled the covers over my head and slept with a baseball bat, I could manage it.
When I began to learn about investing, risk reemerged as one half of the most important duality in finance, the relationship between risk and return. In this context, however, risk didn’t mean quite what it did elsewhere. Risk wasn’t tip-toeing past Cujo; it was a confusing mix of statistics and dread.
The many meanings of risk
As I leafed through prospectuses and investment literature, risk seemed to be everywhere, yet the meaning of the term was tough to pin down. Concepts such as credit risk, the chance that a bond would default, or shortfall risk, the chance that I wouldn’t accumulate enough assets to reach a financial goal, were straightforward and consistent with my intuitive sense of risk as “the possibility that something bad could happen.”
In other contexts, however, risk was a mathematical concept, describing a range of potential outcomes. This usage leads to formulations that seem downright strange. In a speech on long-term interest rates, for example, Federal Reserve Chairman Ben Bernanke talked about “the upside and downside risks to the forecasts of long-term rates.”¹
In Stephen King, there are no upside risks. Downside risk is redundant. When the Federal Reserve is forecasting interest rates, however, Chairman Bernanke is referring to the probabilities that actual rates will be higher or lower than forecast.
Risk versus uncertainty
Bernanke’s use of the term is consistent with economist Frank Knight’s distinction between risk and uncertainty. Knight defines risk as “an uncertainty which can by any method be reduced to an objective, quantitatively determinate probability.”² When we throw a pair of dice, we’re not sure which number will come up, but we can say with certainty that the risk of snake eyes is 1 in 36.
Uncertainty, by contrast, is “not susceptible to measurement.”³ Something bad (or good) might happen, but we have no way to estimate how likely it is.
The investment community has adopted Knight’s definition of risk to describe the return distributions of different asset classes. On average, stocks have produced higher returns than bonds, but with a wider range of potential outcomes according to a more-or-less normal probability distribution. Stocks are thus “riskier.” In this context, risk refers to standard deviationor variance.
The terms risk and uncertainty are often used interchangeably, but as Knight notes, it’s important to parse the differences because the response to each is different.
We can manage risk through diversification and asset allocation. On the other hand, we can’t calibrate our exposure to uncertainty. Just as it’s a fact of life, uncertainty is a fact of investing. We confront the unknown by trying to make sensible judgments about what might happen and by “treating the future with the humility it deserves,” as our chief economist, Joe Davis, likes to say.
For example, I invest as if the patterns that have characterized the historical relationship between stocks and bonds will prevail in the future. Once I accept that uncertainty, I have a framework for managing the more probabilistic risks associated with different asset classes and investment objectives.
I’ll accept the greater risks of stocks in an effort to earn higher returns and accumulate enough assets for an important financial goal. I may wind up on the wrong side of the probability distribution, but I can manage the variability of outcomes by holding a portfolio that is widely diversified across the stock and bond markets. And if I can find ways to increase my savings, I can chip away at any potential shortfall even when the financial markets are less generous than expected.
² Knight, Frank H., 1921. Risk, Uncertainty, and Profit. Boston: Hart, Schaffner & Marx; Houghton Mifflin Co. http://www.econlib.org/library/Knight/knRUP.html
Notes: All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss. Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income