Risk Is Uncertainty of Lifetime Consumption

RISK has many definitions in finance. It can be standard deviation or volatility, anomalous events, principal loss, or a loss of purchasing power from inflation. In reality, it is all these things to a varying degree at different times, and all of which lead to uncertainty about the future.

I like what Ken French, a Dartmouth College finance professor once said about risk: “Risk is uncertainty of lifetime consumption.” In other words, financial risk is not having enough money at certain times in life. This could result from taking too much risk, not taking enough risk, or even taking the wrong types of risk. But in the end what we’re all striving for is having enough money to be able to pay for things in the future.

The reason we diversify our assets and use financial instruments like cash, bonds or insurance is because the future is so uncertain. In financial planning you hope for the best and plan for the worst.

A properly constructed portfolio must account for this unpredictability and help you navigate all of life’s uncertainty. This is why it’s so essential to start with a holistic financial plan that allows you to understand how things like income, expenses, insurance, and asset allocation all work together to help you optimize certainty across your lifetime.

In this context it’s important to understand the role of different instruments in a portfolio. For example, cash will provide you with virtually unmatched principal protection over the short term and relatively poor inflation protection over the long term. Stocks, on the other hand, are uncertain in terms of principal protection over the short term, but provide you with a very high level of inflation protection in the long term. As depicted in Figure 0.5, you can think of short-term principal protection and purchasing power protection as relative trade-offs.

Figure 0.5: Scale of purchasing power versus permanent loss protection

When you blend stocks and bonds, you are creating diversification across both purchasing power protection and principal protection. This helps diversify your portfolio and gives you greater certainty of consumption by reducing the degree to which any particular instrument exposes you to extreme purchasing power or principal risk.

This is the main reason asset class diversification works. It gives you greater certainty of consumption over time by reducing portfolio performance variance.

The portfolios in this book were selected because they can be utilized within a financial plan to help you increase certainty of consumption over time.