Risk is more than an important part of investing. The whole concept of a financial market exists on the basis that taking risk can result in financial gain. If you do not take risk in financial markets, you expect very low returns. Of course, with risk also comes the potential for loss. Elroy Dimson of the London School of Economics said “Risk means more things can happen than will happen”.

In other words, risk means that there is a distribution of outcomes, and you will not know which outcome you actually get until it happens. As much as we like to think that we can understand risk, the possible distribution of outcomes is beyond our ability to comprehend.

While we are not able to control or predict the distribution of outcomes, we are able to choose the type and amount of risk that we take with our investments.

In this episode of Common Sense Investing, I’m going to tell you about risk.

To start this discussion, I need to introduce two types of risk. The first type of risk is called idiosyncratic risk, which may also be referred to as company specific risk, or diversifiable risk. Idiosyncratic risk is not directly related to the market as a whole. Individual stocks will typically move to some extent with the market, but they may also fluctuate due to their specific circumstances. Think about Volkswagen’s share price plummeting after their emissions scandal.

There is no reason to expect a positive outcome for taking on idiosyncratic risk. It may work out in your favour, but it may result in substantial and unrecoverable losses. Idiosyncratic risk can be diversified away. Owning all of the stocks in the market eliminates the specific risks of each company. What is left is market risk.

Market risk is the risk of the market as a whole. It cannot be diversified away. For taking on the risk of the market, investors do expect a positive long-term return. When you invest in one stock, or one sector, you are getting exposure to both market risk and idiosyncratic risk, but the idiosyncratic risk can easily dominate the outcome. The most reliable long-term outcome would be expected when idiosyncratic is diversified away. Practically, this simply means owning a globally diversified portfolio of index funds, an idea that is not new to anyone who has been watching my videos.

Most investors do not own a 100% equity portfolio. Portfolios will typically consist of some mix between equity index funds and bond index funds. Long-term outcomes are uncertain, but we know that over the past 116 years stocks have outperformed bonds globally, while bonds have been less volatile. A portfolio becomes less risky and has a lower expected return as the allocation to bonds increases.

The decision about how much risk to take is driven by the ability, willingness, and need to take risk.

Equity market risk has tended to pay off over long periods of time, and the distribution of outcomes also tends to narrow. For example, over the 877 overlapping 15 year periods from 1928 to 2015, the US market outperformed risk-free t-bills 96% of the time. The ability to take risk is primarily driven by time horizon and human capital. We have been talking about risk as an unpredictable distribution of outcomes. A more tangible definition might be the probability of not meeting your goals.

For a young person with lots of remaining earning capacity, the market underperforming t-bills hardly affects their ability to meet their goals – in fact, it would be a good opportunity for them to buy cheap stocks. On the other hand, a near-retiree taking substantial losses in the years leading up to retirement would be devastating to their ability to meet their spending goals. In general, it is sensible to take less risk for goals with short time horizons and more risk for goals with long time horizons.

Even with an unlimited ability to take risk, most investors are constrained by their own willingness to take risk. An investor may look at the history of market risk and decide that it is too volatile for their preferences. The MSCI All Country World Index was down 33% in Canadian dollars between March 2008 and February 2009.  That’s a pretty big drop. In his book Antfragile, Nassim Taleb introduced what he calls the Lucretius Problem: we tend to view the worst historical outcome as the worst possible outcome, but that is nowhere near the truth. If a 33% drop scares you, you would need to be comfortable with the potential for a far deeper decline to be confident investing in a 100% equity portfolio.

The need to take risk brings us back to goals. If someone wants to spend $5,000 per month adjusted for inflation for a 30-year retirement, they would need about $2.5 million dollars to be able to afford to take no risk. They could hold cash in a bank account and deplete their assets over time without any volatility. Most people do not accumulate enough to fund a risk-free retirement, so they must introduce some level of risk.

The right amount of market risk in a portfolio is sufficient to hopefully meet the goal for the assets without introducing the potential for catastrophic failure due to large declines at the wrong time. There are rules of thumb out there, like having 100 minus your age in stocks, but they have little basis. Truly there is no optimal answer, but there is little debate that expected returns are highest with a 100% equity portfolio, and investors will add in bonds to match their ability, willingness, and need to take risk.