How Do You Measure Risk When it Comes to Investing?

It’s easy to make money in the market, especially in the good years, and most of the years are good.

When it comes to investing, how do you measure risk? originally appeared on Quora, the place to gain and share knowledge, empowering people to learn from others and better understand the world. You can follow Quora on Twitter, Facebook, and Google Plus.

The act of investing can be defined as forgoing consumption today to make money in uncertain ventures in the hope of increasing one’s ability to consume in the future. Thus investing entails making decisions regarding the future, even though the future can’t be known with confidence. It boils down to the conscious acceptance of risk in pursuit of return. Most people think about investing primarily in terms of the return they might make, but clearly there are not one but two important elements: return and risk. In other words, the amount of money made and the risk borne to make it. Both must be considered by any intelligent investor.

It’s easy to make money in the market, especially in the good years, and most of the years are good. If you look at historical returns, they’ve been good most of the time, and good on average over the long term.

After roughly 50 years in the business, I’m convinced that risk is the more important, intriguing and difficult part of investing. Risk, not return, is what distinguishes the superior investor: whatever the return may be, I’m convinced the superior investor achieves it with less risk than others.

In order to determine whether an investor did a good job, we have to look at something called “risk-adjusted return,” which considers both the return that was achieved and the risk that was taken in the process. But whereas return is easily measured and stated, risk is not.

In an attempt to quantify risk, finance academics and theoreticians in the early 1960s chose volatility as the measure of risk. Volatility – or how much an asset price or a stream of returns has fluctuated over time – is easy to quantify. For me, that’s volatility’s greatest advantage. The problem is that, in my opinion, and in the eyes of most investors, volatility is not the real risk (although it might be viewed as a symptom or product of risk).

Therein lies the problem: historic volatility can be measured, but for me, it isn’t risk. On the other hand, risk the way I define it – the probability of future loss – is something that can’t be measured. In general, the probability of a future event can’t be measured: it’s just a matter of opinion.

Because of my doubts about the relevance of volatility, the formulas that calculate risk-adjusted return using volatility as the measure of risk, while easy to apply, are not completely appropriate. Thus the question of how much risk of loss was borne can only be a matter of subjective opinion. For this reason, adjusting for risk, while important, isn’t easy.

Risk is something that the intelligent investor either (a) avoids if it’s intolerable in the absolute or (b) demands compensation to bear. I’ve never heard anyone say, “I’m not going to make that investment: it might be volatile.” What they say is, “I’m not going to make that investment: I might lose money.” Thus I reject defining risk as volatility. For me, risk is mainly the probability of losing money.

The future isn’t known or knowable. In fact, I don’t think the future has been determined yet, so how can it be known today? It can only be guessed at, but investors can try to add value by enumerating the possible outcomes and estimating their probabilities. Thus we have to think about the future in terms of a probability distribution. What’s most likely to happen? What other outcomes are nearly as likely? What are the improbable possibilities, or “tail events”? How likely are they, and what would be their consequences? These are things we can estimate but not know.

And it’s essential to remember that even if we’re right about the possible outcomes and their respective probabilities, we still don’t know which one is going to happen. Thus uncertainty – risk – is generally inescapable. So, in other words:

* Many outcomes are possible.

* We can’t know which of them will happen.

* At best we can list them and assign them probabilities.

* Even if we do so correctly, the actual outcome will still be in doubt.

* Invariably there is the risk that some of the outcomes that materialize will be unpleasant.

* The uncertainty surrounding which outcome will materialize, and the possibility that it will be a bad one, are the source of risk.

This question originally appeared on Quora. More questions on Quora:

* Stock Markets: How do I master the market cycle?

* Investing: What are some ways to adapt to changes in the market cycle?

* Finance: Why do you study market cycle trends?

Photo Credit: DigitalVision/Getty Images