I once had a student who came into my office and eagerly declared, “I want to invest in stocks!”

I asked him why.

He said, “my roommates are all making so much money, I want in! They bought AMC at $10 and it’s now $50!”

One important marker that separates a beginning investor from a more mature investor is their understanding of risk. Beginner investors who have been regaled by tales of easy money rarely consider risk properly.

But what does it mean to properly consider risk?

Calculating risk

The traditional way to consider risk is to simply calculate it. When calculating risk, most investors use a statistical measure of dispersion around a historical average such as standard deviation, volatility, beta or downside deviation.

For example, if I had a stock that has historically returned 10% per year with a 20% standard deviation, then 95% of the time that stock is predicted to create a return that is between -30% and +50% (i.e., 2 standard deviations +/- the average return). The higher the standard deviation, the more potential for the investment to deviate far from its average return.

Once the preferred measure of risk is calculated, then an investor is considered “grown up” if they then seek to maximize their risk-adjusted returns. A common way to measure risk-adjusted returns is to use the Sharpe ratio, which essentially takes the expected return of an investment and divides it by a measure of risk. The higher the Sharpe ratio, the more return you are getting given the same amount of risk.

There is more to risk than numbers

So, is that it? Is considering risk properly simply a matter of calculating risk-adjusted returns?

I have never been satisfied to stop at risk-adjusted returns — there is something more that needs to be considered. What if risk is not just a matter of the head, but also of the heart? Put a