by David Moon
The investment industry has lied to you. Risk is not volatility. Investment risk is not standard deviation, beta or some other statistic masquerading as a Greek letter. Regardless of the how many fancy reports you’ve received stating otherwise, risk cannot be measured to two decimal places.
Variability in the price of an investment, or group of investments, plays a role in one type of risk: the risk that you might be forced to liquidate an investment at an inopportune time. This is a risk faced by short sellers, those who invest with borrowed money, people who own illiquid assets or people who have money invested in stocks that is likely to be liquidated in the next three years or so for any reason, including to pay bills. If you don’t control when you sell an investment, volatility is a risk.
To the 35-year-old who is saving for retirement, price volatility is the opposite of risk: it is opportunity. This person should be concerned about other risks, like valuation, interest rate, inflation, quality and liquidity risk.
Valuation risk is the possibility of paying more for an asset than it is worth. If you pay $800 a square foot for a downtown Knoxville condo, you may have a great home, but you have subjected yourself to significant, self-inflicted valuation risk. It could be years before you have the opportunity to sell a poorly purchased asset at a gain.
Interest rate risk is usually associated with increases in rates, not declines. When the overall level of investment yields increase, prices of existing fixed cash flow investments, especially bonds, typically decline in order to increase the asset’s available return on investment. That is, rates go up, prices go down.
With few short-term exceptions (including recent mild rate increases) interest rates have been in an almost constant decline since 1982. As a result, this is an often overlooked risk.
An even more frequently overlooked risk is inflation risk. It’s easy to understand why; we haven’t experienced real inflation in decades. From 1977 to 1996, the consumer price index increased an average of 4.87 percent annually. Since 1997, inflation has averaged only 2.03 percent. Investors in their 40s have little-to-no personal experience with an inflationary environment and, as a result, don’t really understand that inflation is a monetary termite. Yet for these investors, inflation risk is much more important than price volatility.
Quality risk is associated with buying an asset that diminishes in value after you purchase it. Maybe you purchased some Puerto Rico bonds that quit making interest payments in January, or drug-maker Valeant before its price-gouging scandal and its 90 percent stock price drop. Thorough analysis and reasonable diversification can minimize quality risk.
There are many types of investment risk. Defining risk solely as price volatility is convenient, but naive.
David Moon is president of Moon Capital Management. This article originally appeared in the USA TODAY NETWORK.