Many investment advisors would tell you that, according to modern portfolio theory, risk can be defined as the variance of actual returns compared to the expected return. In addition to being financial jargon, I think this is wrong.
I believe a better definition of risk is the possibility of principal loss. This means an actual, realized loss of your original investment, not just interim up-and-down price fluctuations while you hold the asset. Aside from putting cash in the bank or investing in short-term US Treasury bills, every investment involves some amount of risk that you won’t get all your money back. The key is understanding these risks, eliminating some of them, then finding risks you are willing to live with, and choosing investments that expose you to only those risks.
I spent the majority of my investing career focused on identifying and mitigating risks associated with individual private equity investments: liquidity risk, business risk, credit risk, inflation risk, currency risk, etc. Fortunately for us as individual investors, all these risks can be practically eliminated by owning a diversified stock portfolio. And interest rate risk can be mitigated by owning a short-term bond portfolio. The primary risk that remains is market risk: the risk that the price of an asset or an entire portfolio can decline for a period of time. This is the prudent risk that we as investors should take. The reward is substantial: over the long run, a diversified portfolio of stocks has returned 10% per year on average. A 10% return doubles your money approximately every seven years. And in exchange for this considerable return, all we have to do is not sell our portfolio of stocks when prices are down.
“Can any of you by worrying add a single hour to your life?” – Matthew 6:27