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Idiosyncratic Ideas about Risk

In thinking about the risks associated with investing in stocks, investors tend to think in idiosyncratic terms. What I think of as risk, for example, may be quite different from what you think of as risk. This has partly to do with our individual circumstances and partly to do with our differing temperaments. It's important, of course, to understand ourselves as investors and to know what we mean by risk. But it's far more important to understand that the capital markets don't care about what we think of as risk.

If risk to me means never experiencing a negative return in any calendar year, I can design a portfolio that will be highly likely to avoid that particular risk. But to do so I will have to sacrifice far more return than I probably want to give up. In other words, I'm being penny-wise and pound-foolish.

If risk to you, on the other hand, means failing to achieve at least a 15 percent annual return from a traditional stock and bond portfolio, you can probably accomplish that, too. But you will be exposing yourself to breathtaking price volatility, volatility so great that you will almost certainly abandon the portfolio long before it has generated your desired rate of return.

And the same is true of other idiosyncratic definitions of risk. Hence, it's crucially important that we understand the real risks that are embedded in the capital markets. We can still indulge our “eccentric” ideas about risk, but at least we will understand something ...