What Is Risk?
You're an investor. Investing involves risk. But what, exactly, is risk?
My favorite definitions of risk come from financial advisor Carl Richards. "Risk is what's left over when you think you've thought of everything else," he writes in his book The Behavior Gap.
But there are other ways to think about risk. In a recent article in TheWall Street Journal, Zvi Bodie and Rachelle Taqqu argue that investing in the stock market is more risky than most give credit to. Among several reasons cited, they write:
There are a number of different approaches that demonstrate why the conventional wisdom about stocks is wrong. One of them has to do with bear markets, which happen regularly; the long growth stretch that began in 1983 and lasted through the 1990s has not been the norm. And the longer you hold onto your stocks, the greater your chances of running into one of those downturns.
I'm not so sure. There are several ways to interpret market plunges. The great bear markets of the last decade may resemble risk for some. For others, they were anything but.
Charlie Munger, Berkshire Hathaway's vice chairman, describes risk like this:
Using volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.
Risk, in other words, isn't when stocks go up and down. That's just something stocks do. Risk is when stocks go down and can reasonably be expected to stay down forever.
Take two companies, Altria and Citigroup. Both saw their share prices plunge in 2008, but for very different reasons.
Citigroup shares plunged because the company had to issue billions of new shares (many to the U.S. government) in order to survive. By diluting existing investors and having to shut down divisions that used to be profit drivers for the company, it suffered a true permanent loss. Its share price decline represented a deep and irreparable wound, not a temporary swing of market volatility. That's risk. And sure enough, shares are still 95% below their pre-recession high. They may never surpass 2006 levels again.
Altria, on the other hand, saw its shares fall almost 40% in 2008 because... well, no one really knows why. Adjusted for spinoffs, Altria's normalized net income grew 8.5% in 2008 and 6% in 2009 -- pretty good! The company raised its dividend throughout the crisis -- even better! The collapse in Altria's shares represented nothing more than a contraction of its valuation. Shares just got cheaper, in other words. That's not risk; it's opportunity. And sure enough, shares have since boomed to an all-time high.
Distinguishing between risk and opportunity is important to successful investing. Just consider the recent bear market that so many associate with "risk." After one of the strongest rallies in history, the Dow Jones is now at an all-time high adjusted for dividends.
Think about what that means for long-term buy-and-hold investors. It means that, for several years, they were given the opportunity to buy great companies at some of the best prices they may ever see again. And they only had to wait four years to regain all of their losses. If that equals risk, I'll take all I can get.
This article originally appeared onDailyfinance.com.