As an investment advisor, I think about risk and elements of risk far more than I think about return. But risk is one of those words that appears precise until we attempt to define it… so let’s put some context to risk. In finance, it may refer to volatility, the probability of loss, the possibility of failing to meet an objective, or simply the unsettling realization that the future has declined to provide us with its itinerary! However, risk is not confined to finance or markets. Human existence is an extended encounter with incomplete information. We choose careers without knowing how industries will change, form relationships without guarantees, make health decisions using imperfect evidence, and develop plans that depend on circumstances beyond our control. Even the decision to avoid risk introduces risks of its own: stagnation, missed opportunities, declining purchasing power, or excessive caution.
Then there is uncertainty. Uncertainly is closely related to risk but conceptually distinct. Risk generally describes situations in which possible outcomes (and sometimes their probabilities) can be estimated. Uncertainty concerns what cannot be confidently measured or anticipated. We can estimate the likelihood of many familiar events, but life also produces surprises that resist historical comparison. Reality, after all, has never considered itself bound by the assumptions in my financial or investment models.
For practical purposes, uncertainty may be included within a broad definition of risk. Still, in my opinion, the distinction remains useful. Volatility is visible and measurable; uncertainty is often neither. Volatility is basically a statistical calculation that tells us how widely observed outcomes have varied. Uncertainty reminds us that the future is under no obligation to resemble the past… and often does not. With that said, human beings do not experience risk as a purely mathematical concept. We interpret it through emotion, memory, personality, social expectations, and personal circumstance. The same uncertain event may represent an exciting opportunity to one person and at the same time an unacceptable threat to another. This leads to an important distinction between risk tolerance and risk capacity… one of my favorite investment advisory topics!
Risk tolerance describes a person’s emotional willingness to accept uncertainty, volatility, or loss. It concerns temperament. How does an individual respond when circumstances deteriorate? Can that person remain patient and deliberate, or does discomfort create an urgent desire to act as action may feel better than waiting? Risk capacity, by contrast, describes the person’s practical ability to withstand an adverse outcome. It depends on circumstances rather than disposition: time horizon, health circumstance, income stability, available resources, obligations, support systems, and the flexibility to delay or revise plans. These two concepts of risk are not always copasetic. A person may feel entirely comfortable taking substantial investment risk yet lack the capacity to endure a major decline shortly before a planned withdrawal. Confidence is admirable, but it does not satisfy an imminent obligation. Emotional comfort cannot repair a mismatch between volatile assets and near-term needs.
The same distinction appears throughout life. An entrepreneur may possess a high tolerance for uncertainty but lack the financial reserves or personal flexibility required to survive an extended period without income. Another person may dislike uncertainty intensely while having strong professional alternatives, substantial savings, supportive relationships, and few fixed obligations. The first person may feel able to take the risk without being able to bear its consequences. The second may be able to bear the consequences while finding the experience deeply unpleasant.
A appropriate investment strategy (or life strategy for that matter) must consider both risk tolerance and capacity. Ignoring tolerance may produce a plan that cannot be followed when conditions become stressful. Ignoring capacity may produce one whose consequences cannot be absorbed. In either case, the elegance of the strategy becomes irrelevant if it must be abandoned at the worst possible moment. This is why purpose and time horizon are essential. Resources intended to meet obligations within the next several years have a different function from assets intended to support spending decades in the future. Near-term obligations, for example, are often better matched with cash, Treasuries, or high-quality bonds. Not for all situations and circumstance but it is a common pairing (like a light Pinot Noir with grilled salmon). The primary purpose of the Treasuries or cash equivalent is not necessarily to achieve the highest available return – it is to remain available when needed (see my recent piece, “Why a Long-Term Portfolio Needs Both Growth and Stability” (1)). Longer-term capital has a different assignment. Assets intended to support distant objectives may be positioned more heavily toward equities because they have more time to endure market cycles and participate in economic growth. Equity volatility remains real, but a longer horizon may provide the flexibility to wait, adjust, and avoid selling during temporary declines.
A similar principle applies beyond investing. Short-term responsibilities generally require reliability and reserves. Long-term ambitions permit greater experimentation because there is more time to recover, learn, and change direction. The risk appropriate for a distant aspiration may be entirely unsuitable for next month’s essential obligation (e.g. a certain CPA’s iced, tall, American with a splash of vanilla sweet cream). More broadly, every choice protects against certain risks while creating exposure to others. A stable career may reduce near-term income uncertainty while increasing dependence on a single employer or industry. Entrepreneurship may create professional autonomy while introducing financial instability. Delaying an important decision may reduce discomfort today… but it might worsen the potential consequences in the future. There is rarely a risk-free option; there are usually only different collections of risk.
Sound risk assessment is less an expression of optimism or pessimism than an exercise in matching resources, responsibilities, and time horizons. It recognizes that uncertainty cannot be eliminated, only organized. Near-term needs call for resilience against immediate disruption. Long-term objectives call for resilience against inflation, insufficient growth, changing circumstances, and the gradual erosion of opportunity. The purpose of a thoughtful strategy is not to demonstrate bravery in the presence of uncertainty. Nor is it to avoid every uncomfortable outcome. It is to distinguish between risks that may be necessary to pursue an objective, risks that may offer potential compensation, risks that can be transferred or reduced, and risks that could threaten essential objectives. Risk, in the end, is not merely a characteristic of an investment or a decision. It is a relationship among uncertainty, objectives, time, circumstances, and human behavior. A strategy becomes suitable not when it seeks to eliminates but when it allows a person to live with uncertainty without permitting a foreseeable setback to become an irreversible one. That may be the most practical definition of risk management: not predicting the future, but building a life and a portfolio that do not require the prediction to be perfect.
Sources:
1. https://www.eastfranklincapital.com/why-a-long-term-portfolio-needs-both-growth-and-stability/
