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What is risk?

What is risk and do we understand it in the personal investment context?  Whether saving for a home, retirement or college do we truly understand risk?  Economists and finance people categorize risk in various ways: investment risk, interest rate risk, systemic risk, systematic risk, default risk, market risk - blah, blah risk.  But for us, individuals, we don’t need all these different classifications of risk.  Bottom line for us are we losing money.

Wall Street spend lots of money and other resources on trying to measure or quantify risk.  They also spend resources on trying to limit or avoid risks.  As we can tell from this current financial crisis they didn’t do a good job with handling risk.  Unfortunately, for us, this has impacted us through our investments for 401k or IRAs, college savings or just general investing. 

Just because Wall Street did a horrible job with risk doesn’t mean we should do the same.  Risk for us is the risk of losing everything or almost everything in our various investment accounts (401k, IRA, College Savings Plans, mutual funds).  Unfortunately for me, I have experienced significant loss.  During the dot com bubble, I invested in companies such as WorldCom, EMC and Global Crossing.  I lost a lot of money - it was hard and very discouraging.  It definitely changed how I view risk and it changed my investment strategy.

The issue is are we investing in risky investments such stock mutual funds or other stock investments or even some bond funds without fully understanding the risks.  One of the common questions that financial planners/advisors ask clients is “how much risk can you accept” or “how do you feel about risk” or something very similar.  The problem is how is a person who has not experienced risk of losing everything or almost everything going to fully appreciate risk.  If the only thing a person knows or has experienced is an increasing stock market (or even real estate prices) how can that person comprehend losing money?

Here is the thing.  If we are trying to achieve something that is very meaningful to us, such retiring at the age of 59 or paying for our children’s college, why are we willing to risk achieving that goal or objective by making risky investments?  Investing in stocks is a risky investment.  I am thinking out loud at this point but why do we did it?  Is it because our financial planner/advisor told us so, is it because a friend is having a “good winning streak” in the stock market.  Why?

We need to start really examining the risks we take with our money.  Are we being fully compensated or achieving a high enough investment return for those risks?  Are we willing to accept losing everything or almost everything or postponing a goal because of investment losses? 

Remember, high investment returns means higher risk that is because we need to be compensated for taking the risk.  So, if a stock mutual fund is earning only a 4% return is it worth investing in that fund knowing that stocks are risky investments.  If, I am investing in stocks, I want a much higher return or I am looking for other investments particularly ones that are more conservative. 

I hope this was helpful.

Good luck.