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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parvus
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Re: Risk = ??

Post by parvus »

The Biology of Risk:
In one of my studies, conducted with 17 traders on a trading floor in London, we found that their cortisol levels rose 68 percent over an eight-day period as volatility increased. Subsequent, as yet unpublished, studies suggest to us that this cortisol response to volatility is common in the financial community. A question then arose: Does this cortisol response affect a person’s risk taking? In a follow-up study, my colleagues from the department of medicine pharmacologically raised the cortisol levels of a group of 36 volunteers by a similar 69 percent over eight days. We gauged their risk appetite by means of a computerized gambling task. The results, published recently in the Proceedings of the National Academy of Sciences, showed that the volunteers’ appetite for risk fell 44 percent.

Most models in economics and finance assume that risk preferences are a stable trait, much like your height. But this assumption, as our studies suggest, is misleading. Humans are designed with shifting risk preferences. They are an integral part of our response to stress, or challenge.

When opportunities abound, a potent cocktail of dopamine — a neurotransmitter operating along the pleasure pathways of the brain — and testosterone encourages us to expand our risk taking, a physical transformation I refer to as “the hour between dog and wolf.” One such opportunity is a brief spike in market volatility, for this presents a chance to make money. But if volatility rises for a long period, the prolonged uncertainty leads us to subconsciously conclude that we no longer understand what is happening and then cortisol scales back our risk taking. In this way our risk taking calibrates to the amount of uncertainty and threat in the environment.

Under conditions of extreme volatility, such as a crisis, traders, investors and indeed whole companies can freeze up in risk aversion, and this helps push a bear market into a crash. Unfortunately, this risk aversion occurs at just the wrong time, for these crises are precisely when markets offer the most attractive opportunities, and when the economy most needs people to take risks. The real challenge for Wall Street, I now believe, is not so much fear and greed as it is these silent and large shifts in risk appetite.
Nice work though: flame out as a Wall Street trader and present yourself as a university crash test dummy.
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Re: Risk = ??

Post by poedin »

Interesting take on diversifying into foreign equities versus high percentage domestic biases

http://patrickoshag.tumblr.com/post/932 ... patriotism
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Re: Risk = ??

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New paper by Luihi Zingales at al explores hiw risk aversion is not constant, but rather depends on recent experiences:
We use a repeated survey of an Italian bank’s clients to test whether investors’ risk aversion increases following the 2008 financial crisis. We find that both a qualitative and a quantitative measure of risk aversion increases substantially after the crisis. This increase is present even among investors who did not suffer any financial loss and are unlikely to have suffered a reduction in their lifetime income. To test whether this increase might be an emotional response triggered by a scary experience, we conduct a lab experiment. Consistent with a fear-based explanation, we find that subjects who watched a horror movie exhibit a higher risk aversion than subjects who did not. The size of the increase in risk aversion caused by the horror movie is similar to the one experienced by our bank’s clients during the crisis.
Gosh. Perhaps financial advisers, before interviewing clients on attitude to risk, should inquire as to what movies they have seen recently.

Another consequence is that, when things are going well, investors are less risk-averse,required rates of return decrease, and asset prices rise (bubble, anyone?) Conversely, when things are going badly, investors become more risk-averse, demand higher risk premia, and so drive asset prices down even further.

Momentum investing, anyone?

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Re: Risk = ??

Post by Flaccidsteele »

ghariton wrote:New paper by Luihi Zingales at al explores hiw risk aversion is not constant, but rather depends on recent experiences:
We use a repeated survey of an Italian bank’s clients to test whether investors’ risk aversion increases following the 2008 financial crisis. We find that both a qualitative and a quantitative measure of risk aversion increases substantially after the crisis. This increase is present even among investors who did not suffer any financial loss and are unlikely to have suffered a reduction in their lifetime income. To test whether this increase might be an emotional response triggered by a scary experience, we conduct a lab experiment. Consistent with a fear-based explanation, we find that subjects who watched a horror movie exhibit a higher risk aversion than subjects who did not. The size of the increase in risk aversion caused by the horror movie is similar to the one experienced by our bank’s clients during the crisis.
Gosh. Perhaps financial advisers, before interviewing clients on attitude to risk, should inquire as to what movies they have seen recently.

Another consequence is that, when things are going well, investors are less risk-averse,required rates of return decrease, and asset prices rise (bubble, anyone?) Conversely, when things are going badly, investors become more risk-averse, demand higher risk premia, and so drive asset prices down even further.

Momentum investing, anyone?

George
This seems somewhat related to Baader-Meinhof syndrome/recency illusion cognitive bias.

One of my beliefs when I was younger was that investing success was due to financial knowledge. After doing modestly well, I realized that I was terribly misguided. Investing success has more to do with individuals with better emotional bias management taking advantage of others who didn't. After that revelation, things became easier for me...and allowed my math skills to degrade to a grade-school level...
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Re: Risk = ??

Post by George$ »

Flaccidsteele wrote: ...
This seems somewhat related to Baader-Meinhof syndrome/recency illusion cognitive bias.
I found this interesting - but I am not familiar with your reference here. What might your background be?
Flaccidsteele wrote:One of my beliefs when I was younger was that investing success was due to financial knowledge. After doing modestly well, I realized that I was terribly misguided.
Likewise I spent about 10 years when I was young (from 1962 to 197?) - searching for the "wise and smart" investor managers - and funds - until I realized that was foolish and naïve on my part
Flaccidsteele wrote: Investing success has more to do with individuals with better emotional bias management taking advantage of others who didn't. After that revelation, things became easier for me...and allowed my math skills to degrade to a grade-school level...
Why the "taking advantage of others"?

Can I ask - "What do you understand by investment 'risk' ?"
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Re: Risk = ??

Post by Flaccidsteele »

George$ wrote:I found this interesting - but I am not familiar with your reference here. What might your background be?
Nerd is probably accurate.
George$ wrote:
Flaccidsteele wrote: Investing success has more to do with individuals with better emotional bias management taking advantage of others who didn't. After that revelation, things became easier for me...and allowed my math skills to degrade to a grade-school level...
Why the "taking advantage of others"?
Perhaps a poor choice of words on my part. I sometimes say that I take advantage of (what) the market (gives me), but the market as a whole is comprised of others, so I'm taking advantage of others. The market (or others), as a whole, appears to have poor emotional bias management.

There might be a better way to phrase this idea.
George$ wrote:Can I ask - "What do you understand by investment 'risk' ?"
I'm not sure about the direction of this open probe so I'll just answer it in a generalized form.

I understand when I have a lack of knowledge in an asset class that increases my investment risk.
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Re: Risk = ??

Post by parvus »

George$ wrote:
Flaccidsteele wrote: ...
This seems somewhat related to Baader-Meinhof syndrome/recency illusion cognitive bias.
I found this interesting - but I am not familiar with your reference here. What might your background be?
George$, in the 1970s, some student activists got a bit out of control. In the U.S., the Students for a Democratic Society splinter, the Weather Underground, managed to blow some of themselves up in fancy parents' townhouses in Greenwich Village whilst trying to assemble bombs. In Germany, the extra-parliamentary opposition, upset with their position of sybaritic privilege, targeted the new bosses and leaders who had served under the Nazi regime, allied themselves with Palestinian terrorists (the apple doesn't fall from the tree, does it?) and this is what led to the German Autumn. Which is to say the Baader Meinhof gang were well-educated terrorists, like the Brigatte Rosse in Italy operating at the same time. What this has to do with investing, I have no clue. Perhaps FS can enlighten us with more than a throwaway line.
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Re: Risk = ??

Post by Spudd »

Parvus, that's not what he was referring to.

http://en.wikipedia.org/wiki/List_of_co ... y_illusion
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Re: Risk = ??

Post by George$ »

Howard Marks at Oaktree is always worth reading carefully - as Warren Buffett advises.

Thus his recent article on "Risk Revisited" (14 pages) is worth reading and re-reading.

He starts with "volatility ... falls far short as the definition of investment risk"
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Re: Risk = ??

Post by ghariton »

George$ wrote:Howard Marks at Oaktree
Yes. I tried to cut and paste a paragraph from that letter a few days ago, but I was unable to. However, given the ongoing discussion, I'll type out the first bit of the paragraph (apologies for typos):
While I don't think risk and volatility are synonymous, there's no doubt that volatility does present risk. If circumstances cause you to sell a volatile investment at the wrong time, you might turn a downward fluctuation into a permanent loss. Moreover, even in the absence of a need for liquidity, volatility can prey on investors' emotions, reducing the probability they'll do the right thing. And in the short run, it can be very difficult to differentiate between a downward fluctuation and a permanent loss. Often this can be done really only in retrospect. Thus it is clear that a professional investor may have to bear the consequences for a temporary downward fluctuation simply because of its resemblance to a permanent loss. When you're under pressure, the distinction between "volatility" and "loss" can seem only semantic.
(emphasis added)

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Re: Risk = ??

Post by Flaccidsteele »

George$ wrote:He starts with "volatility ... falls far short as the definition of investment risk"
For better or worse, I share this extremely unconventional perspective.

To me, spending so much effort managing volatility is like cutting off one's nose to spite their face. It has serious long-term consequences.
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Re: Risk = ??

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Flaccidsteele wrote:For better or worse, I share this extremely unconventional perspective.
IMHO risk is ultimately a subjective concept. While one can calculate historical rates of various events happening, and one can use models (mathematical or mental) to guess at regularities that might repeat, ultimately I'm making decisions based on my perceptions (and biases).

As a result there are measures that I find useful, and others not so useful. For me, the notion of permanent loss falls in the latter category. So I have to search elsewhere.

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Re: Risk = ??

Post by LadyGeek »

Another qualitative perspective is that many associate risk with loss. To say that one's portfolio is risky implies that it has a high probability of a steep decline in value.

Risk is not defined in one direction. A risky portfolio can also have a large gain in the expected return. This is clear in the formal definitions (volatility), but the general perception and somewhat common use of the term means to decline in value.
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Re: Risk = ??

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LadyGeek wrote:Risk is not defined in one direction. A risky portfolio can also have a large gain in the expected return.
Do you mean a decline in expected return, or an actual return that falls short of the expected return? I think that most people mean the second, although the first is probably more useful, at least to me.

As for the asymmetry. Harry Markowitz in his original work (his Ph.D. thesis) played around with the idea of using the semi-variance, i.e. the variance but only counting negative deviations. In practice, however, it has turned out that the variance and the semi-variance give roughly the same message (at least for equities), and the variance is easier to work with.

And then there is the distinction of diversifiable versus non-diversifiable risk. Variance or beta? And if beta, is there a single beta, of several?

One frequent definition of risk is the probability of permanent loss. Unfortunately, that is incomplete -- it does not take into account the magnitude of the loss. So for example I find a 10% probability of a small loss less risky than a 1% chance of a very large loss.

There is also the problem of the definition of "loss". Is it a decline in market value in nominal dollars? In real (i.e. after inflation) dollars? Or is it against a benchmark of sorts, e.g. what I could have earned by investing in a saf4e (e.g. government) bond?

Finally there is the problem of "permanent". It seems to me that a loss is permanent only when either (a) I sell a security at a loss (whatever that means) or (b) the issuer becomes insolvent. Otherwise, the value of the security might recover, and so my loss is (not yet) permanent. If this approach is adopted, the easy way to reduce risk is to be a buy-and-hold investor -- much more effective than diversification. Somehow that doesn't seem to be a useful concept.

Maybe the problem is that risk is multi-dimensional and resists attempts to capture it with a single number. I think that this is most easily seen when thinking about bonds. Here there are at least three distinct sources of risk (1) market risk, due to changing -- rising -- interest rates (2) credit risk, regarding the solvency of the issuer (3) liquidity risk, e.t. what happens when the markets seize up and I want to sell, or more prosaically what haircut I must accept if I want to sell in a hurry. Some would add inflation risk as a fourth category, but others would include it in market risk. Clearly no one measure can summarize adequately those different risks.

But humans love simplicity. Hence the popularity of all-encompassing single measures.

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Re: Risk = ??

Post by Flaccidsteele »

ghariton wrote:
Flaccidsteele wrote:For better or worse, I share this extremely unconventional perspective.
IMHO risk is ultimately a subjective concept. While one can calculate historical rates of various events happening, and one can use models (mathematical or mental) to guess at regularities that might repeat, ultimately I'm making decisions based on my perceptions (and biases).

As a result there are measures that I find useful, and others not so useful. For me, the notion of permanent loss falls in the latter category. So I have to search elsewhere.

George
I completely agree.
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Re: Risk = ??

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ghariton wrote:
LadyGeek wrote:Risk is not defined in one direction. A risky portfolio can also have a large gain in the expected return.
Do you mean a decline in expected return, or an actual return that falls short of the expected return? I think that most people mean the second, although the first is probably more useful, at least to me.
I meant that return can also go higher than predicted (exceed expectations). Most think of shortfalls, which is my point. It's a debate of terminology between common usage and textbook definitions.
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Re: Risk = ??

Post by parvus »

Spudd wrote:Parvus, that's not what he was referring to.

http://en.wikipedia.org/wiki/List_of_co ... y_illusion
Recency is different from the Baader-Meinhoff gang. There is no evidence that this is the appropriate nomenclature. If silly bugger economists, betrayed by theorems of marginal utility, are going to humble themselves before the findings of social psychology, then they should try to get it right. (Yeah, I have a degree in social psychology, "halo effect," "cognitive dissonance" and all that neat stuff.)

Wiki here has it wrong. It's bogus. There is no Baader Meinhoff syndrome/investing illusion, unless what is meant is to shoot the fascist bosses.

It's a bit like the commonly repeated myth that income taxes were "temporarily" imposed during the First World War. No. Income taxes were a municipal domain, granted by the provinces. But that's a longer story.
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Re: Risk = ??

Post by BRIAN5000 »

George$ wrote:Howard Marks at Oaktree is always worth reading carefully - as Warren Buffett advises.

Thus his recent article on "Risk Revisited" (14 pages) is worth reading and re-reading.

He starts with "volatility ... falls far short as the definition of investment risk"
IMHO theres lots of good info in that article but what it all boils down to in the end is diversifiction and asset allocation can be used to mitigate/lessen the 24 or more risks mentioned in the article.
This information is believed to be from reliable sources but may include rumor and speculation. Accuracy is not guaranteed
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Re: Risk = ??

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I know that this article is principally about the level of the market, rather than risk per se, but I find this bit illuminating as to the nature of risk:
But the longer we go without a stock-market pullback, the harder it will be for investors to handle when it inevitably occurs. A stable market breeds complacency. Complacency breeds bad investing behavior. Bad investing behavior breeds regret.

<snip>

Here are a few things to keep in mind when thinking about how to react to the market's next inevitable correction.

How long can you stick around? Risk in the stock market is less about wondering whether a pullback will come and more about asking how long you can remain invested.

Having money invested in stocks that you may need for living expenses within the next five years dramatically increases the odds of falling victim to the market's inevitable volatility. Keeping a larger portion of your assets in bonds or cash might damp returns in the short run, but it's a small price to pay if it offers enough flexibility to ensure that money you have in stocks can remain invested for the longer haul, where returns are the greatest.
Again, volatility may not be the same as risk, but following this line of thought, it is a powerful contributor to it.

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Re: Risk = ??

Post by Flaccidsteele »

I also agree that volatility is not the same as risk.

In my naive opinion...

Assuming an individual is a semi-decent saver, and the only thing they did was regularly/passively invest in a low-fee equity index (e.g. couch potato); after a decade, they will have a significant sum, and after a couple decades, they can probably retire.

And if they were a rabid saver and had the emotional fortitude to "double down" during market meltdowns (and continue with their regular passive investments otherwise), they could probably significantly shorten that timeline. And they would likely have a small fortune at the age of 65.

However, as I mentioned in previous threads, most individuals spend a lifetime fearfully attempting to manage volatility (by conventional diversification, asset-allocation, re-balancing, etc.) to a point where, during their retirement, their portfolio (paradoxically) cannot handle volatility.

Conventional volatility management protocols increase the fragility of an investment portfolio the longer that they are employed.
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Re: Risk = ??

Post by OnlyMyOpinion »

Flaccidsteele wrote:regularly/passively invest in a low-fee equity index (e.g. couch potato)...However most individuals spend a lifetime fearfully attempting to manage volatility (by conventional diversification, asset-allocation, re-balancing, etc.)
Then there is CCP's discussion of risk and asset allocation: http://canadiancouchpotato.com/2010/11/ ... take-risk/, with a link to Vanguard's comparison of historical portfolio returns: https://personal.vanguard.com/us/insigh ... llocations for further consideration.
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Re: Risk = ??

Post by ghariton »

The Problems With Risk Questionnaires:
What people say they believe about financial risk and the way they think they’ll act under market stress is often contradicted by their behavior. Long-term investors frequently become short-sighted at the first sign of trouble. Many times this reaction is brought on by answering an investment questionnaire under the influence of recency bias.

<snip>

Taking a risk tolerance questionnaire during one five-minute period on one day in your life isn’t going to uncover your actual ability to handle a loss. For questionnaires to be useful, they should be completed under different market conditions. Author and financial advisor Allan Roth finds, “The way we feel about risk is remarkably unstable—we think we are risk-tolerant when stocks are at an all-time high only to find we are risk-averse when stocks plunge.”
I would go further. I don't think any number of questionnaires are a substitute for actually having lived through a bear market, as a gauge of risk (in)tolerance.

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Re: Risk = ??

Post by Shakespeare »

"There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own." - Fred Schwed
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Re: Risk = ??

Post by Flaccidsteele »

ghariton wrote:I would go further. I don't think any number of questionnaires are a substitute for actually having lived through a bear market, as a gauge of risk (in)tolerance.

George
Shakespeare wrote:"There are certain things that cannot be adequately explained to a virgin either by words or pictures. Nor can any description I might offer here even approximate what it feels like to lose a real chunk of money that you used to own." - Fred Schwed
I agree.

However, having said that. Aside from research, the only purpose for a "risk" (misnomer for "volatility") questionnaire is as a sales tool used to manage/minimize potential objections and to funnel a prospective client into whatever the salesperson wants to sell them.

It's standard practice.
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Re: Risk = ??

Post by ghariton »

An older article by Campbell Harvey (from 2000) suggesting that skewness is an important factor in explaining asset prices and returns. The abstract:
If asset returns have systematic skewness, expected returns should include rewards
for accepting this risk. We formalize this intuition with an asset pricing
model that incorporates conditional skewness. Our results show that conditional
skewness helps explain the cross-sectional variation of expected returns across
assets and is significant even when factors based on size and book-to-market are
included. Systematic skewness is economically important and commands a risk
premium, on average, of 3.60 percent per year. Our results suggest that the momentum
effect is related to systematic skewness. The low expected return momentum
portfolios have higher skewness than high expected return portfolios.
It seems intuitive to me that skewness is a risk factor over and above volatility. Yet I can find very few articles or papers discussing this. Does anyone have any references, more recent than this one, which they think are particularly illuminating?

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