Risk must be measured by . . .

Probability

Percentage

Period

I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.
— John Stuart Mill, 19th Century English Philosopher

Probability

Risk must be measured in terms of the probability that some sort of portfolio loss can occur. Note that portfolios can be constructed to consider and mitigate those losses having a reasonable opportunity of occurring. However, portfolios cannot be structured to avoid every loss that while hypothetically possible is improbable. Nuclear war, bankruptcy of the Federal government, and the dissolution of all companies in the S&P 500 index are examples of remotely possible but unlikely events around which portfolio actions cannot be taken.

Percentage

Probable losses should be measured in real terms or the preservation of purchasing power over the investor's time horizon. In other words, investors should consider not just how many dollars they possess at the end of their investment time horizon but how much they can buy with those dollars. Consider the fate of $1,000 tucked away safely in your mattress on January 1, 1995. When you finally remove the money on December 31, 2014, you still have 1,000 one-dollar bills. However, each of those dollars retains only 63 cents of its original purchasing power.

Inflation is a Loss


Period

Risk has a time dimension that causes the probability of loss to change of any given investment when differing time periods are considered. However, the dimension of risk is not static over time. Consider the S&P 500 stock market index. Investing with a one-day time horizon exposes an investor to a high percentage chance of loss. Yet, that risk of loss diminishes over longer holding periods.

S&P 500 Losing Periods 1926 - 2014

The number of periods in which an investor holding the S&P 500 index for the entire period would have experienced a decline in portfolio value. Note that it is not possible to invest directly in an index. Statistics were calculated by Wayne Firebaugh, Inc., using data obtained from Dimensional Fund Advisors, Inc. 

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