More on risk

We defined risk as the chance of losing money when you sell your investment. We need to make 2 refinements to this working definition.

1. In investments, risk is defined more broadly as the chance of receiving a return that is different from the return we expected to make.

Risk, in fact, includes not only bad outcomes such as lower than expected returns, but also good outcomes like higher than expected returns.

Thus, if the expected returns of an investment is 5%, the risk that you will earn a 10% return or 0% is exactly the same. In other words, using standard deviation, you do not distinguish between downside risk and upside risk.

For this reason, some investors may not be completely comfortable with standard deviation as a measure of risk.

They may go for:

• a measurement called the semi-variance where only returns that fall below the expected return are considered.
• they may go for simpler yet common-sensical proxies for risk. For example, it makes sense that stocks of technology companies are riskier than those of food companies. Others prefer to create ranking categories. (For example, ranking money market instruments as lower risk and technology stocks at higher risk.)

2. There are also investments whose expected return is known ahead of time.

For example, when you buy a bond that pays a fixed interest payment every six months and the return of principal at maturity, you can tell ahead of time what your actual return will be.