Understanding risk and volatility

There is no single definition of what risk means for investors.  According to legendary value investor Ben Graham risk is “the possibility of not getting your capital back.”  That is consistent with how many investors see risk – and was an entirely appropriate way to have thought of investing in finance companies pre-GFC.    This is essentially the measure of risk that credit rating agencies give us when investing in corporate debt.

Risk and modern portfolio theory

Harry Markowitz (the father of modern portfolio theory) defined risk differently.  He identified it as having two characteristics:

1. Volatility of return
2. Systematic and non-systematic risk

We are going to focus on part 1) of the definition (volatility) but let’s quickly look at part 2).  “Systematic risk” is all risk inherent in a portfolio that cannot be mitigated by diversification.  Influences such as interest rate changes, war, recession and political change impact entire markets and not only individual companies.  If you are invested when markets are dealing with significant political change (a systematic risk) there is nowhere to hide no matter how diversified your portfolio may be.