There are essentially two ways one can measure risk: math and perspective. Usually if there are numbers involved an assessment can be done using concepts like probability. But for most of the risks we take in our day to day lives, honest conversations with ourselves and the ones who know us best are the best tools. To be sure, perspective is almost always needed when measuring risk; whether it’s an investment in your IRA or proposing to your girlfriend, it’s always helpful.
The most common way to look at risk in the investment world is with standard deviation. This statistic places a numerical value on how far up or down a security’s price fluctuates from its long-term average. The higher the standard deviation, the “spikier” a chart of the historical price will look. Over the last three years the US stock market has had a standard deviation of about 18.6. This number doesn’t mean much by itself but if it is compared to another investment you can start to see what the value tells us. For example, the US bond market (traditionally thought of as a conservative investment) has had a standard deviation of just 3.5 over that same period. One could say that stocks have been 5 times as risky as bonds. That is also one of the reasons they tend to have much better rates of return over time.
Once we have gotten a feel for an investment’s risk level statistically, we then need to put that in perspective. This can be achieved partly by determining your investment time horizon, which is just a fancy way of asking “when do you need the money”? For example, if you have $100,000 in your bank account that is going to be used as a down payment for a house you plan on buying next year, your time horizon is very short, and the money should most likely stay in your savings account where it has no risk at all. But if that house is being purchased in 10 years after you retire then obviously, we are working with something a little different.
As we can see, your time horizon has a huge impact on how much risk you should be taking on, but that is not the only thing that can impact your risk tolerance. Your past experiences can also contribute to your perspective. How were your investments positioned during the bear market of 2008-2009? Did you sell when things were down and miss out on the ride up? What if you just don’t need to take risk? Perhaps you have a great pension and Social Security in retirement, and you are just not that interested in the returns you might experience with that new aggressive growth fund your neighbor keeps talking about. Maybe he doesn’t have a pension and is behind the 8-ball with retirement savings. Now that’s perspective.