One of the most important concepts that an investor needs to understand is the difference between risk and uncertainty. Larry Swedroe and Kevin Grogan, in their book, "The Only Guide You’ll Ever Need for the Right Financial Plan," explain this important concept.
The book quotes Frank Knight’s definitions of risk and uncertainty; “Risk is present when future events occur with measurable probability. Uncertainty is present when the likelihood of future events is indefinite or incalculable.”
What is an example of risk? Flipping a fair coin. For any flip of the coin, you have a 50% chance of heads and a 50% chance of tails. There are no other possible outcomes.
Uncertainty is quite different. Prior to September 11, 2001, did you know that two airliners would bring down the World Trade Center Towers? Did you know that one plane would be an American Airlines plane, and one would be a United Airlines plane? Did you short both American Airlines and United Airlines stock on September 10th? If you did, how did your subsequent visit from the FBI go?
The events of September 11th were unpredictable and, therefore, unquantifiable to investors. That’s what news is; random and uncertain. Much academic research demonstrates that the price of any security, at any time, is the total of all of the information both public (news) and private. Although we talk about stock risk, the correct statement is stock price uncertainty. Stock prices in freely traded markets are driven by information. Information that is random and unknowable in advance. This is why a mountain of academic evidence shows that few, if any, people can consistently predict stock prices accurately.
Today the distinction between stock risk and uncertainty is very important. We have had tremendous stock gains since the spring of 2009 (almost six years). $10,000 invested in Vanguard’s S&P 500 stock fund (ticker: VFINX) on March 3, 2009 grew to $33,903.41 as of March 3, 2015 (reference: Morningstar). That 339% return over that past six years has lead many investors to believe that stock prices are calculable risk.
Swedroe and Grogan point out that this is common during bull markets. As they say, “Their “ability” to estimate the odds gives investors a false sense of confidence, leading them to decide on an equity allocation exceeding their ability, willingness, and need to take risk.”
As an investment advisor, I see this today. I am amazed at the number of people in financially precarious situations (in their 60s with little savings, no pension, and modest social security benefits) who tell me that they have no problem holding 60% or more of their savings in stocks. I’ll ask them if they would they be ok with a $30,000 decline in their $100,000 portfolio (which is the decline that investors experienced in 2008 with a 60% stock/40% bond portfolio)? They assure me that they would. Can someone in this situation remain invested, let alone rebalance into a declining market, when they open their statement and see a $30,000 decline in their portfolio? Not likely.
A successful investor realizes that stock price changes are unpredictable. You cannot calculate the odds like you can for a flip of a coin or a spin at the roulette wheel. This awareness will help an investor build a more intelligent portfolio.