What is Risk?

If you study finance in college like I did, one of the first terms you will hear is "risk" - but what does it mean, really?

I would propose the following: "Risk" as it is defined in finance does not mean what many people think it does.

You will often hear "High risk = high return" and conversely "Low risk entails low returns". This is used to mean that investing in stocks is riskier than investing in corporate bonds, which is riskier than investing in treasury bonds, which is riskier than holding cash - but as you take on more risk you will get a higher average return. Risk in this context means volatility - how much the market price varies from day to day.

For example, let's suspend reality and assume for a moment that the notions we hold about the US stock market are true. We will assume that the average return, and the standard deviation of those returns are a set fact. I believe this is actually more or less the case for the foreseeable future, but it's a matter of opinion, so let's just stipulate that it's mathematical fact for purposes of argument.

If this is the case, then there is roughly a 50% chance that the stock market will lose money on any single day. Looking at the opposite extreme, there is a 100% chance that you will make money in the stock market if you buy and hold the market for 20 years. This is historically true, and if you believe the statistical properties you can derive from past data, then it is also basically true going forward. So, you might say that investing in stocks for a period of 20 years or more is "risk free".

Since we are talking about Japan, we can look at inflation adjusted numbers for the Nikke 225 and TOPIX over the last 20 years for comparison:

• 142% for the Nikkei 225
• 238% for the TOPIX

In fact, neither of these indexes has ever lost money in real terms over a rolling 20 year period.

On the other hand, holding onto cash is very risky - or put a different way, "risk free" in the negative sense. There is nearly a 100% chance that it will lose significant purchasing power over the same 20 years. Yes, Japan did have a bout of deflation, but that is a blip in the history of currency movements world-wide. Even with the long period of deflation, the real value of the yen fell 21% over than last 20 years.

That means if you started with 10 man yen invested in the Nikkei 225 10 years ago, you would now have 310,000 JPY today. If you held it in cash, you would have, well, 100,000 JPY today. The Yen has dropped in value in either case, but at least by investing in the Nikkei you gained a lot more than the Yen lost (And this is ignoring the dividends you would have received in the meantime).

The fact that you would have gained more by investing isn't really the point - that's almost a given. Rather, the point is that if you believe that we know the statistical properties of the market, and that those aren't going to fundamentally change in our lifetimes, then you made those gains by taking on now additional risk. We "knew" that over 20 years, you had basically a 100% chance of making money, and we knew on average how much it would be.

So when you hear the financial news talk about "risk", know that they are talking about the day to day swings. Technically speaking, this usually means variance or related measures like the standard deviation - but what they are really talking about is the difference between the expected returns (i.e. the average returns) vs. the actual returns. These are just measurements to tell you how random the market is, how messy the trend line is.

Since we endorse index funds, this mainly refers to systematic market risk. To be sure, the market can fall because of an earthquake, a pandemic, or a rainy day. The market can also rise with a new PM, new treaties, or nice weather.

If you zoom out, though, all of this noise fades into the background. In this context, "Risk" means the waviness of a line, which really just indicates how long you should look to stay invested to ensure making a profit.

Assuming there are no large fundamental changes to the market, risk fades to zero over the long term. Importantly, this long term is still much shorter than a human lifetime.

So that's it, then, right? Simply invest all your money into the market for at least 20 years, and you have guaranteed profit? Well, sort-of.

The problem in real life is that there are different kinds of "risks", like the risk that you will lose your job, that the economy will tank, that you will need to fix your roof, move, etc. Those risks require a buffer of money so as to avoid needing to remove money from your investments - otherwise you can't keep your money invested for 20 years.

In my experience, people underestimate the chance that something surprising will happen. Nobody expected 9.11 or 3.11, and people don't expect to get divorced, hate their job, or get into a car accident, etc., either.

To those who think that the stock market has, or will fundamentally change - maybe you're right, but everyone who has thought so in the past has been wrong. I believe that sitting on the sidelines is a far greater risk. If you aren't confident about Japan's future, fine, invest internationally. If you are worried about the global stock market, then what you are really worried about is the future of humanity. The stock market is made up of businesses, and I believe that profitable businesses will always exist and that it will always make sense to invest in them.

What has changed is that our generation has the ability to easily invest in thousands of businesses worldwide at the touch of a button, starting with small amounts, and often for free - and tax free. Investing used to be only for those who were already wealthy, so I treat this democratization of finance as relatively recent privilege that that more people should take advantage of.

In the end, I believe you can make money in the stock market "risk free" - but it requires having enough of a cushion to cover life's risks. I think more people should invest, and people should invest more, but I also think that many investors keep too little of their portfolio cash. How much is the right amount? The amount that lets you cover the unexpected and lets you sleep at night. Any more than that, and you are missing out on the returns of the stock market. Any less, and you might be tempted to sell at the worst time - and that is the worst risk.