Risk = ??

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor. Seeking advice on your portfolio?

If Risk = Standard Deviation, then

Poll ended at 05 Sep 2005 11:48

Risk is a probability of a loss
2
11%
Risk is a measure of uncertainty
12
63%
None of the above
5
26%
 
Total votes: 19

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Peculiar_Investor
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Re: Risk = ??

Post by Peculiar_Investor » 29 Dec 2015 08:38

From a recently published interview with Howard Marks of Oaktree Capital, «The Risks Today Are Substantial» | International Selection | Finanz und Wirtschaft, the following offers a pretty decent viewpoint to be considered IMHO
Howard Marks wrote:Academics say risk equals volatility and the nice thing about volatility is that it gives them a number they can manipulate and use in their formulas. But I don’t worry about volatility and I don’t think most investors are worried about volatility. We know prices will go up and down. But if something is going to be worth a lot more in the future than it is today we’re going to buy it regardless. So people don’t worry about volatility. What they worry about is the potential of losing money.

<snip>

Most people think that there is a positive relationship between risk and return: If you make riskier investments you can expect a higher return. That’s total nonsense! Because if riskier assets could be counted on for higher returns than they wouldn’t be riskier. The reality is that if you make riskier investments you have to perceive that there will be a higher return or else you have no motivation to make that investment. But it doesn’t have to happen: If you increase the riskiness of your investments the expected return rises. But at the same time the range of outcomes becomes greater and the bad outcomes become worse. That’s risk and that’s what people have to think about.
I would definitely concur with the viewpoint on volatility not being risk.

The second paragraph definitely resonates with my views.
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Re: Risk = ??

Post by SQRT » 29 Dec 2015 10:46

OK. But other than semantics what do we do differently? Ie how does the concept of risk affect our actions?

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Re: Risk = ??

Post by Shakespeare » 29 Dec 2015 11:31

Volatility is undesireable during withdrawal because it increases sequence of returns risk.
“A wise man should be prepared to abandon his baggage at any time.” -- R.A. Heinlein, The Door Into Summer.

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Re: Risk = ??

Post by AltaRed » 29 Dec 2015 12:32

Shakespeare wrote:Volatility is undesireable during withdrawal because it increases sequence of returns risk.
A reason why many investors, if their SWR can handle it, have a reserve of cash or similar assets to cover the bad years. I choose this methodology since I cannot predict bond yield direction with any certainty either. Granted bad years can persist longer than one can remain solvent, aka Japan, but the ability to cover 3-5 years reduces sequence of returns risk.
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Re: Risk = ??

Post by ghariton » 29 Dec 2015 12:43

Peculiar_Investor wrote:I would definitely concur with the viewpoint on volatility not being risk.
I agree that volatility is only one aspect of risk. But it is a very important one. Apart from creating sequence-of-returns risk as pointed out by Shakespeare, volatility affects investors' subjective perceptions of the desirability of investing in a product. We know this, because volatility is priced in the market. Indeed, in formulas such as Black-Scholes for pricing options, the link between the premium and the volatility is explicit. While Black-Scholes is something of a simplification, variations are still used in practice.

High volatility drives some investors out of the market altogether.

I find the second paragraph something of a tautology. If an investment is risky, then while an investor might expect a higher return, he doesn't necessarily earn one. Duh!

The confusion here is between expected returns and actual returns. Higher expected volatility correlates with higher expected returns, not higher actual returns. (Markets are a random walk with upward drift. We're talking about the magnitude of the drift.)

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Re: Risk = ??

Post by longinvest » 29 Dec 2015 13:42

ghariton wrote:
Peculiar_Investor wrote:I would definitely concur with the viewpoint on volatility not being risk.
I agree that volatility is only one aspect of risk. But it is a very important one. Apart from creating sequence-of-returns risk as pointed out by Shakespeare, volatility affects investors' subjective perceptions of the desirability of investing in a product. We know this, because volatility is priced in the market. Indeed, in formulas such as Black-Scholes for pricing options, the link between the premium and the volatility is explicit. While Black-Scholes is something of a simplification, variations are still used in practice.

High volatility drives some investors out of the market altogether.

I find the second paragraph something of a tautology. If an investment is risky, then while an investor might expect a higher return, he doesn't necessarily earn one. Duh!

The confusion here is between expected returns and actual returns. Higher expected volatility correlates with higher expected returns, not higher actual returns. (Markets are a random walk with upward drift. We're talking about the magnitude of the drift.)

George
Thanks George. I agree with your opinion.

I still struggle with the concept of "expected return". I've been able to determine that it definitely doesn't mean what I intuitively thought, the first time I've heard the term.
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Re: Risk = ??

Post by ghariton » 29 Dec 2015 22:33

longinvest wrote:I still struggle with the concept of "expected return". I've been able to determine that it definitely doesn't mean what I intuitively thought, the first time I've heard the term.
I have two different, incompatible definitions to offer.

For the first, we assume that the return from an asset or portfolio in a future period follows a probability distribution (a tautology if one is a Bayesian like me). First estimate the probability distribution. There are many ways to do this, including Monte Carlo simulations of different outcomes, or use of historical data, augmented by (informed) judgement. The resulting probability has a mean, i.e. expected return, and a variance, i.e. the expected probability. Theory says that there is a trade-off between these two.

For the first, we take a survey of (relatively informed) investors, to see what they think the future return might be. Plot this as a histogram. The mean is the expected return, and the variance is the expected volatility.

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Re: Risk = ??

Post by Flaccidsteele » 29 Dec 2015 23:06

Howard Marks wrote:Academics say risk equals volatility and the nice thing about volatility is that it gives them a number they can manipulate and use in their formulas. But I don’t worry about volatility and I don’t think most investors are worried about volatility. We know prices will go up and down. But if something is going to be worth a lot more in the future than it is today we’re going to buy it regardless. So people don’t worry about volatility. What they worry about is the potential of losing money.
I understand what Marks is saying, but he's using the term 'investors' very loosely here. A specific type of investor isn't worried about volatility, but in general, 'investors' are worried about volatility. At least worried enough that they create systems in an attempt to minimize it.

Personally I don't care about volatility. Volatility has been good to me over the years. Without volatility there is absolutely no way I could have retired when I did. Volatility created environments that allowed me to purchase assets where, in a non-volatility world, I could never afford. Ever.
Howard Marks wrote:Most people think that there is a positive relationship between risk and return: If you make riskier investments you can expect a higher return. That’s total nonsense! Because if riskier assets could be counted on for higher returns than they wouldn’t be riskier. The reality is that if you make riskier investments you have to perceive that there will be a higher return or else you have no motivation to make that investment. But it doesn’t have to happen: If you increase the riskiness of your investments the expected return rises. But at the same time the range of outcomes becomes greater and the bad outcomes become worse. That’s risk and that’s what people have to think about.
Completely agree with the second paragraph. For me, I have no desire to increase risk in order to chase some perceived increase in returns. All I need is a period of high volatility in an asset class where I have some knowledge. That's it. Compounding over time does the rest.

With regards to sequence-of-returns risk, this is only a factor if an investor consciously decides to focus on a singular asset class (e.g. stocks). Most individuals should quickly become aware that sequence-of-returns risk could affect their ability to retire when they want to retire. It should be apparent very early with stocks, for example. At this point the investor should focus on learning about assets that pay out regular streams of income whether that is bonds, private mortgages/MICS, rentals, whatever. And then wait for volatility to hit them. After these kinds of assets are secured, sequence-of-return risk is significantly minimized.

With regards to 'volatility being priced into the market'. I again agree with Marks when he says that, "Academics say risk equals volatility and the nice thing about volatility is that it gives them a number they can manipulate and use in their formulas".
ghariton wrote:High volatility drives some investors out of the market altogether.
This, and the low price associated with driving out investors, is the biggest benefit of volatility. Especially for individuals with very long time horizons.
Retired @ 40 after reading Munger/Buffett. I avoided a fragile retirement by avoiding conventional volatility management (diversification, re-balancing and asset-allocation). "Put 90% in a very low-cost S&P 500 index fund...the long-term results will be superior" - Warren Buffett

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Re: Risk = ??

Post by FinEcon » 30 Dec 2015 10:29

ghariton wrote: For the first, we assume that the return from an asset or portfolio in a future period follows a probability distribution (a tautology if one is a Bayesian like me). First estimate the probability distribution. There are many ways to do this, including Monte Carlo simulations of different outcomes, or use of historical data, augmented by (informed) judgement. The resulting probability has a mean, i.e. expected return, and a variance, i.e. the expected probability. Theory says that there is a trade-off between these two.

For the first, we take a survey of (relatively informed) investors, to see what they think the future return might be. Plot this as a histogram. The mean is the expected return, and the variance is the expected volatility.

George
I lost you when the overwhelming sound of laughter filled the (virtual) room. This might be a nice, tight explanation for a scenario in a classroom when students (and professors) need something to do buy it but it's not investors behave in the real world. Most investors do fairly simple back of the envelope calculations and think the deal through as best they can given the facts than can be cheaply/easily ascertained.

George, I'm evaluating a car wash property bundled with an adjacent lot and my banker wants me to produce a Monte Carlo simulation complete with nicely colored plots. The graph must be red whenever the risk of ruin point is crossed. She also has deep concerns about the value of the stochastic error term and is unsure that I've considered dispersion correctly, something about mean absolute deviation being not Greek enough for her. Perhaps you can help a brother out.
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Re: Risk = ??

Post by longinvest » 30 Dec 2015 14:01

George simply stated two distinct (and incompatible) definitions of "expected returns". He also said that he was a Bayesian. Here's what Wikipedia says about that:
Bayesian probability is one interpretation of the concept of probability. In contrast to interpreting probability as frequency or propensity of some phenomenon, Bayesian probability is a quantity that we assign to represent a state of knowledge,[1] or a state of belief.[2] In the Bayesian view, a probability is assigned to a hypothesis, whereas under frequentist inference, a hypothesis is typically tested without being assigned a probability
All this comforts me into not putting any personal belief into "expected returns" numbers I see floating around.

I simply admit that I don't know what future returns will be. I only know that investment-grade bonds pay coupons and pay back their capital at maturity, and that stocks can pay dividends and the underlying company often grows its assets. Everything else is speculation*, including the current price of a bond** or the current price of a stock***. Note that an ETF is just a collection of bonds or stocks.

* It is speculation (hope to make a profit) in the sense that the price is only determined by the existence of a buyer willing to pay an amount of money for the financial asset.
** Many people think that the prices of bonds are determined by interest rates. I believe that it's the other way around; that interest rates are determined by the prices that people are willing to pay for bonds with specific coupons, principals, maturity dates, and credit quality.
*** The price of a stock is determined by the amount a buyer is willing to pay for the possible future dividend stream and perceived future growth of the company and its assets.

Obviously, the price of an investment-grade bond maturing soon is much less volatile than the price of a stock. As a result, the price of a broad market bond ETF, such as VAB, is much less volatile than the price of a broad market stock ETF such as VCN, because a significant number of bonds (40% of VAB) will mature in less than 5 years.

Why worry about volatility? Because it is important to me that I can extract money from my investments when the need for it shows. I don't want the market to (completely) decide when I'm allowed to extract money from my investments.
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Re: Risk = ??

Post by ghariton » 30 Dec 2015 14:13

FinEcon wrote: it's not investors behave in the real world. Most investors do fairly simple back of the envelope calculations and think the deal through as best they can given the facts than can be cheaply/easily ascertained.
I was giving a framework for organizing the information we do have. Monte Carlo simulations, and analysis of historic performances were two examples of such data. So is licking one's finger and waving it about in the air, I suppose.

You are right that the average retail investor doesn't have very good information underlying his stock-picking and investing generally. It seems to me that reliance is on anecdote rather than analysis. So yes, considerations of expected return and risk don't have much of a role to play.

The other use to which my framework can be put is to realize how little we indeed know (thank you for the help, longinvest). This leads to a different course of action. In my case, it is ceasing to pick stocks or time the market, and instead buy-and-hold very broad market indexes. If that's where all the thinking and reading leads one, then I think it is time very well spent.

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Re: Risk = ??

Post by SkaSka » 19 Aug 2016 17:17

I found this an interesting thought experiment on how a diversified portfolio along the lines of modern portfolio theory in the early 20th century would have fared when a major black swan event like WWI came along.
This well-intentioned, balanced portfolio would be in for a wild ride in the next decade and possibly drawdowns of as much as 80%. The saving grace would have been to invest in Detroit startups or other investments that successfully straddled wars, Russian revolution, crises and the technological boom of the early 20th century.

Sokoloff told IBTimes UK: "That thought experiment is really frightening to me. You followed very sound modern portfolio management advice back then and still in ten years your portfolio is gone. I don't think we are really learning the lessons of history, especially now that the global economy is so much more interconnected than it was before."
Wasn't sure where to put it - thought this thread was most appropriate as it deals with portfolio risk.

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Re: Risk = ??

Post by cannew » 23 Aug 2016 13:19

Haven't read all 20 pages of this post, so sorry if it's been mentioned elsewhere.

I think Risk is what one can afford to loose. If your portfolio is $1,000 to $5,000 then a loss of $100 to $500 represents10% of your total investment. If your portfolio is $100,000 or more a $10,000 loss may still be 10% but one may not consider it an unreasonable risk.
Also if one invests for the long term and not in speculative investments than short term losses may not be consider risks.

Buying lotto ticket should be considered risky because the odds are so much against you. I cant think of any stock which offers the same odds of loosing ones money as fast.

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Re: Risk = ??

Post by deaddog » 15 Nov 2016 19:55

The stock market may be volatile at times but that is not what determines risk. Risk is how you respond to the volatility, how you manage the potential size of your losses. The stock market is not risky, the people that play it are. It is how you deal with price volatility that determines risk.
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Re: Risk = ??

Post by longinvest » 15 Nov 2016 20:43

So far, the best definition of risk that I have read is the one given by Zvi Bodie in his book Risk Less and Prosper. The definition itself is short:
In [i]Risk Less and Prosper[/i], Zvi Bodie wrote:
Investment risk is uncertainty that matters.
But, to better appreciate the nuances of this definition, here is the context (I underlined the essential part):
In [i]Risk Less and Prosper[/i], Zvi Bodie wrote:
A few proposed definitions of risk that commonly surface include: the unknown; the chance that something harmful may happen; uncertain outcomes that may cause loss; and uncertainty that arouses fear.

Let’s discard the idea that risk is nothing but the unknown, because risk is more than the ordinary uncertainty that surrounds our lives. By referring to harm, loss, and fear, the next three suggestions reflect one fundamental property of risk: Somebody has to care about the consequences if uncertainty is to be understood as risk.

The notion of “caring” or “mattering” is central. It captures both the potential (objective) impact of uncertainty as well as its (subjective) bite. This brings us close to the definition we’ll adopt: Investment risk is uncertainty that matters. There are two prongs to this definition—the uncertainty, and what matters about it—and both are significant.

So, beyond the odds of hitting a rough patch, there are the consequences of loss to consider.
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Re: Risk = ??

Post by ghariton » 15 Nov 2016 21:11

Two prongs.....

Yes. When I was young we were taught to look at the probability of a loss and the size of the loss if a loss did happen. Multiply the two together (technically, integrate the various sizes of the loss over the density function of that size of loss) and you get expected value of the loss.

But I suspect you (and Bodie) are looking at keeping the two measures separate, not combining them. That raises the question: Is it preferable to incur a small probability of a large loss, or a larger probability of a smaller loss? That will vary with the individual, and so requires thought (which is generally unwelcome).

There is actually a third dimension, the timing of the loss, if it occurs. For example, losing one's job is a loss, but the impact is greater if it occurs at a time when there is an economic downturn, and jobs are scarce. Similarly, I care less if one of my securities is down when my other securities are up. I care more if there is some negative external event, for example my car just got totalled, and I need money for replacement.

I come back to my point that there are multiple measures of risk. Different measures are useful in addressing different questions, or for different people addressing the same question. The financial advice industry has much to answer for, in trying to get clients to use a unidimensional scale (volatility, or probability of loss -- how big a loss? -- or other measures).

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Re: Risk = ??

Post by longinvest » 16 Nov 2016 00:03

George,
ghariton wrote:When I was young we were taught to look at the probability of a loss and the size of the loss if a loss did happen. Multiply the two together (technically, integrate the various sizes of the loss over the density function of that size of loss) and you get expected value of the loss.
Interesting.
ghariton wrote:But I suspect you (and Bodie) are looking at keeping the two measures separate, not combining them. That raises the question: Is it preferable to incur a small probability of a large loss, or a larger probability of a smaller loss? That will vary with the individual, and so requires thought (which is generally unwelcome).
In the book, Bodie insists on building a plan with no probability of a loss relative to one's minimal needs (as much as this is humanly feasible). That's why he insists so much on using government-backed inflation-indexed securities to eliminate the risk of not meeting minimal needs.

But we could go beyond the "no-risk" needs funding and ask your question in the context of funding wants. Does not meeting one's wants matter? Yes, it would matter, but not as much as not meeting one's needs. So, the risk is lower. As for the answer to your question, in that context, it will effectively vary with the investor.
ghariton wrote:There is actually a third dimension, the timing of the loss, if it occurs. For example, losing one's job is a loss, but the impact is greater if it occurs at a time when there is an economic downturn, and jobs are scarce. Similarly, I care less if one of my securities is down when my other securities are up. I care more if there is some negative external event, for example my car just got totalled, and I need money for replacement.


"Uncertainty that matters". Does volatility matter? It might matter a lot if there is a possibility that one needs to make a sizeable withdrawal from a volatile asset during a deep downturn to meet minimal needs, but it might matter less (or not at all) if there's no such possibility.

Your perspective reminds me of William Sharpe's definition of risk: doing badly in bad times. While I like it a lot, it is not as comprehensive as Bodie's.
ghariton wrote:I come back to my point that there are multiple measures of risk. Different measures are useful in addressing different questions, or for different people addressing the same question. The financial advice industry has much to answer for, in trying to get clients to use a unidimensional scale (volatility, or probability of loss -- how big a loss? -- or other measures).
I agree that there are multiple measures of risk. But, I think that Bodie's "uncertainty that matters" is a definition, not a measure of investment risk.
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