Modern finance theory teaches that market risk is measured by the volatility of asset prices. Just calculate the standard deviation of asset returns and there you have it – risk. But risk of what? Volatility measures risk as how much your portfolio varies over time (also to the upside remember). That is ONE way to measure risk but certainly not the only way.
Even early on in finance theory there were other ways discussed to measure risk. One way, is total wealth dispersion. The Psy-Fi blog has a good post on this topic. Here’s an excerpt that I thought was quite on the money;
Trouble is that this is a world in which “risk” is equivalent to “volatility” and minimising risk in this way simply means ensuring that we get a smooth ride, with as few shuddering rises and falls in our portfolio value as possible. It says absolutely nothing about the one number most people investing in stocks for the long term really care about: the value of their portfolio when they come to liquidate it.
Exactly! (By the way, I don’t agree with the post’s conclusions at all but the discussion is on point.) For a retiree the time for ‘gradual liquifecation’ of the portfolio started the day they retired. And that gradual drawdown, manage by the 4% rule, needs to last until the retiree needs it, usually until death. This time frame can be 30 to 50 years long.
The real risk for this individual is that his portfolio will not last those 30 to 50 years adjusted for inflation and taxes. Volatility is an input to this but not the be all end all measure of risk. Savings accounts or short term gov’t bonds have zero risk but the risk of depleting your retirement assets before death is close to 100% with this ‘safe’ choice.
My point is that a retiree must have a plan to address their greatest risk of all – the risk of running out of money. Watching and worrying about volatility is not a plan.