Risk is the variability, or volatility, of expected outcomes. The weather is a good illustration. A forecast gives an average, or expected, temperature for a city on a certain day of the year. In some regions, such as Southern California, there is less variability, or volatility, in temperature for a given day of the year. In other areas, such as Chicago, there is much more variability, or volatility, in temperature for a particular day of the year. Standard deviation is a measure of volatility that looks at how far an actual outcome might be from the average or expected outcome. The standard deviation in weather for a particular day of the year is larger in Chicago than it is in Southern California.
Likewise, for investments, the greater the standard deviation of outcomes or returns, the greater the risk. Investors should be compensated for taking risk and will demand a higher return. In other words, as expected volatility rises, so should the anticipated return.
Not only should you think about the risk associated with your investments, but you should also analyze risks to your financial profile. You need to be objective and consider how another person would view your financial situation. Be honest with yourself so you can identify areas where you might be able to make changes. Do you have a steady income? Do you have an emergency reserve? Do you have a lot of debt? Do you have adequate liquidity? This exercise is known as risk management.
In contrast to risk management, risk tolerance is about personal preferences. It is about how comfortable you are taking on risk. The volatility of returns for different investment choices varies. Just as you need to be objective about the riskiness of your financial profile, you need to be honest about your comfort level with different degrees of volatility. As you consider if you want to be conservative, moderate, or aggressive with your investments, think about your time horizon. The longer your time horizon, the more risk you can assume.
