Why risk is so hard to measure


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Building on this theme of risk that’s capturing my attention as of late, I wanted to drill down a bit further into this discussion of risk.

One of the things I’ve discussed on my podcast has been how traditional tools used by financial advisors and RIAs aren’t sufficient to get a real handle on our risk.

Risk questionnaires, like the kinds Vanguard uses (one of the better ones by the way), don’t accurately capture our real relationship with risk. There are a variety of reasons why that’s the case but for this post, I wanted to focus on just one aspect of risk and that’s our inability to measure it.

Can you measure risk? The investment water snake

Do you remember those toys we had as kids. These water snakes were latex balloons filled with water and shaped like hot dogs. If you tried, it was super slippery and would just squirt out of your hands.

Risk is like an investor’s water snake. It has the interesting property that the more we try to define it and measure it, the more our own awareness changes, our behavior changes. This forces the risk to move, popping up elsewhere in our portfolios.

In John Adams’ Risk, he writes:

The problem for those who seek to devise objective measures of risk is that people to varying degrees modify both their levels of vigilance and their exposure to danger in response to their subjective perceptions of risk.

The modifications in response to an increase in traffic danger, for example, might include fitting better brakes, driving more slowly or carefully, wearing helmets or seat belts or conspicuous clothing, or withdrawing from the threat completely or—in the case of children no longer allowed to play in the street—being withdrawn from the threat by their parents.

Investment risk is always out there.  Because risk is all about how we personalize and internalize it, our behavior changes the more we become aware of it. Like a water snake, its slippery nature causes us to react differently each time we try to get a hold on it.

The Conservation of Risk: not destroyed, just changes form

The upshot of all this is as we become more aware of our tendencies to make bad investment decisions, we actually become better at what we do. We remove risk from one part of our portfolios, but we don’t totally do away with it. We just force it to show up somewhere else in our portfolios.

If we’re buy and holders, we mitigate overtrading and overconfidence — both related and really bad for our performance. But by holding through tumultuous investing environments, we may actually be too exposed at a given point in time. See, we’ve solved one problem by creating another.

This is like its parallel in physics. Matter isn’t destroyed, it just changes form.

Risk on, baby.

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