What risk actually means
Not price swings, but the chance of not having your money when you need it.
Two definitions that get confused
Academic finance measures risk as volatility: how much a price swings around its average. That definition is easy to measure and convenient for models.
For a person, risk is something else: the chance of not reaching your goal. If you need €50,000 in ten years, the risk is ending up with €30,000.
These two definitions often collide. Money in a savings account has zero volatility and a very high risk of missing your long-term goal.
Sequence risk
The order of returns matters, not just their average. Two portfolios with the same average return can end up in very different places if you withdraw money along the way.
A big fall in the first year of retirement, while you are withdrawing money, does far more damage than the same fall in the last year.
That is why the closer you get to the day you need the money, the less your outcome should depend on the market.
The risks that cannot be measured
Models take it for granted that the future will resemble the past. Events that have never happened before show up in no statistic.
Not understanding what you have bought is a risk too. A product you cannot explain in your own words is a risk, whatever the numbers say.
The most useful test is still a simple one: what would have to happen for me to lose everything here, and how unlikely is that really?
Key terms in this lesson
- Sequence risk
- The risk that the order of returns, not their average, wrecks your plan while you are withdrawing money.
- Shortfall risk
- The chance of not having the amount you need on the day you need it.
- Tail risk
- Very rare, very damaging events that models routinely underestimate.
Quick check
Your retirement money, needed in twenty years, sits in a savings account. Which risk is bigger?
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