Risk is uncertainty. Investing risk is distinct from the risk one may take in a game of chance.
In games of chance the odds are known beforehand. The probability of success and failure is known.
Investing is different. There is no way to know all possible outcomes ahead of time. There is also no way to know the probably each outcome will occur. These characteristics make investing risk impossible to quantify precisely.
The 8 Rules of Dividend Investing include both stock price standard deviation and beta. These are both proxies for risk and not risk in itself. Real risk is permanent loss of capital. Sure Dividend uses these measures because they have historically increased returns with less price volatility.
Risk & Return
Rational people don’t take investment risk for the thrill. All things equal, less risk is better than more risk. Riskier investments should provide higher returns. In reality, there is no hard rule that higher risk means higher returns.
Think about Russian roulette. It is very high risk, but the return for winning is the same as the return for not playing – you keep your life. The extremely high risk of Russian roulette is not compensated with high returns. Russian roulette is a fool’s game.
Perceived risk should always be compared to expected return. The higher the expected return, the higher amount of risk is acceptable. Imagine a coin flip game. It costs $1 to play. A ‘heads’ gives you $3. A ‘tails’ means you lose your investment. This is a very high risk investment; there is a 50% chance you lose your investment. It is also an exceptionally profitable investment worth taking every time.
Portfolio Allocation & Risk
The Kelly Formula finds the optimal bet size to maximize wealth for games where all odds and possibilities are known. The stock market is not the place for the Kelly Criterion.
Simple portfolio management rules are better in unknown environments. Investing 1/n of funds in each holding – also called ‘equal weighting’ is a simple and effective heuristic to use for portfolio diversification. The equal weight S&P 500 index fund RSP has significantly outperformed the market capitalization weighted S&P 500 index ETF SPY over the last decade.
