The following essay is a bit abstract and technical.  It does not contain any specific advice you can implement right away, but it can help you become a better investor.

The concept of risk is central to all investment decisions.  Our use of the term “risk” differs from the conventional one.  Here is the difference: the traditional definition of the risk of an asset (found in any finance textbook) refers to its volatility.  This risk is usually measured statistically by the variance or standard deviation of the return of the asset over some period of time.  The greater the volatility, the greater the risk.  (In fact, the two terms are often used interchangeably.)

According to our definition, risk is assessed by: the confidence one places in one’s forecast of an asset’s return.  There is some overlap between the two definitions: presumably the more volatile an asset, the more difficult it is to forecast its return, and the riskier the asset is.

But there are important differences between the two interpretations of “risk.”  According to the traditional (volatility) definition of risk, an asset bears the same risk to all investors.  Not so according to our definition.  We explicitly recognize that investors possess different degrees of knowledge about any given asset.  Thus their assessment of the asset’s risk will also differ.  A given investment might be risky to one investor, yet be relatively safe for another investor who knows the relevant factors that affect the asset’s return.  For example one investor could be an expert in the area of biotechnology; his choice of biotech stocks is so informed as to make the investment safe.  For another investor this field is completely unknown, and for him, such investment is as blind and risky as purchasing a lottery ticket.

Thus, the first crucial difference in the definitions is that the traditional approach regards risk as intrinsic to the asset, while our approach regards risk as personal (but not subjective!).  We can illustrate that the traditional approach is inadequate by using the examples of estimating political risk (e.g. when investing in an emerging market) or default risk.  These risks cannot be judged by referring to past volatility of returns.  Analysts typically try to assess the probability of default and thus sneak in (mathematically) the concept of variance, but clearly the two approaches are not the same.  Judging the risk of assets just by looking at past volatility can be very dangerous, as illustrated by the recent Subprime Loans Crisis.

The two approaches give different prescriptions for reducing risk.  In the traditional approach risk can only be reduced through portfolio diversification.  By combining assets which are not closely correlated the portfolio variance is reduced.  According to our definition diversification may not reduce risk (i.e. confidence in the return) if the investor is ignorant of the characteristics of the portfolio’s assets.

The way to rationally reduce risk goes beyond blind diversification.  An investor can reduce risk by obtaining greater knowledge concerning any potential investment.

In following this suggestion you should recognize the division of labor principle.  No one can be an expert in all fields of investments.  You can devote more time and acquire better understanding by concentrating on just few areas.  By increasing your knowledge in one field, you not only reduce the investment risk, but also gain advantage over other investors in that area.  The market rewards higher returns to risky investments.  If your risk is lower, your return will be higher than the (so-called) risk-adjusted market return.  You will be compensated for a risk that you are not really taking!

Should you invest in coins, real estate, art, commodities?  By now you know our answer.  It depends not only on the potential return, but also on how risky this type of investment is to you.  And depending on your aspirations, the risk of any of the above could be reduced.

Most of this article was published in my newsletter Arie Vilner’s Rational Investment Outlook in December 1991.