Imagine you are asked to play a game at your local casino. If you are already skeptical about this game, then good for you because, in the long run, the house doesn’t lose. But just for the sake of my attempt to make a point, let’s assume that the odds of winning this game are 4 out 5, or 80%. Those are pretty good odds. If you were to play this game at the casino all night, you’d probably end up with some substantial winnings. But now let’s assume that game being played is Russian roulette. Would you still like to play?
Investment advisers define risk as the potential for loss or volatility of returns associated with an investment. They understand that every investment carries a degree of risk and work with their clients to manage that risk through a variety of strategies.
One way investment advisers define risk is by examining the historical performance of an investment. This analysis includes the investment’s volatility, or the degree to which it fluctuates in value over time. Advisers may also consider the correlation between the investment and other assets in a portfolio, as well as the overall market conditions and economic outlook. In this “cognitive” realm, risk takes the form of a statistic such as standard deviation.
Another factor that investment advisers consider when defining risk is an investor’s individual risk tolerance: the degree of risk that an individual is willing and able to take on given their financial goals, time horizon, and overall financial situation. In this “emotional” realm of risk, ideas like exposure and consequences are most important. A high chance of success must be ignored if the low chance of loss is catastrophic like in the Russian roulette example.
When making decisions on how to invest your wealth, it is crucial to consider not just the cognitive side of risk but the emotional side as well. Anyone can look at the historical record of a particular investment and see what the “odds of winning” are, however, often it takes the guidance of an expert to put those odds in perspective and determine what the consequences and exposures are to your personal situation.