The Real Definition of Risk

Today’s article is going to be super short. I am going to talk about risk. 

You may be wondering how such a complex topic can be so brief, so let me explain. 

The Background:

• When I started a million years ago at Merrill Lynch a trainer explained how he approached risk for clients. The short version is he would ask how the client would react if they saw a negative return number on their quarterly statement. If they said it would not bother them he marked their risk tolerance as high/aggressive. If the opposite, he marked them as low/conservative.
• I think the average risk tolerance questionnaires continue to be as brief. Usually about 6-10 questions. 

The Problem:

• Here is the rub when it comes to risk. When markets are doing well most people consider themselves being willing to take on more risk.
• The opposite is true when markets are down. Suddenly these same risk takers are hiding money in the mattresses.
• I use a rather sophisticated software program to gauge risk. Even with this program the above results happen depending on what the market does. 

A Different Mindset:

• I saw something recently that gave what I thought was the best definition of risk.
• Risk has two components. First, permanent loss of capital. Second, actions that reduce the ability to reach your goals. That’s it. 

Conclusion:

• It is still important to take risk questionnaires with your planner. Especially on a regular basis.
• The risk you take at 25 is different than the amount of risk you wish to take at 65.
• However, keep thinking of the definition of risk. I know I won’t forget the two components of risk in my definition.