Traditionally, risk has been quantifiedas some measure of volatility - say, the standard deviation of returns.More recently there have been some efforts to separate risk into its components. I know of Alpha and Beta, which refer to how well correlated an asset's performance is with the relevant index, and how volatile the asset is compared to the index. I don't know which is which. I know there are others.I think that there are so many components to risk, it should be possible to generate unlimited greek-letter measures, all of which are somewhat relevant but only serve to hide the real issues going on.Do you think there is a way (or ways) to measure risk?
Is Risk the same as Volatility? to an unleveraged speculator or investor with a long term horizon, imho the answer is "no". in fact, volatility is beneficial in the sense that it creates opportunities that wouldn't exist otherwise.however, if you are buying treasuries on 10% down 90% margin, with a maintenance level of 7.5%, then you should certainly be concerned about the risk that underlying short term price volatility poses to your net equity.tr
The respected solasis says that risk is not equal to volatility, at least for the unleveraged person. I concur.So why does all the advertising and PR say "Reduce risk by diversifying among asset classes!" ? Is that just advertiser's bunk?I think that when talking about Risk, it makes more sense to define risk as the probability of a particlular event happening. (Being able to retire comfortably, where comfortably is $50,000 a year, inflation adjusted.) This makes sense for certain groups of people (middle-aged, approaching retirement). It can be simulated using a Monte Carlo method (as does www.financialengines.com) or using other statistical techniques.Solasis mentions a scenario where volatility is closely tied to risk-- my guess is that since T-bills' market values are extremely interest rate sensitive, a small change in interest rates is likely to cause a margin call, which is a risk that can determine the probability.However, it doesn't make sense for me, recently graduated from college:- I don't know my future earnings, & can't predict 'em- I don't know my expenses,- I don't know what % I'll be able to save,- I don't know how much I'll withdraw for retirement.In such a vacuum of information, I can't use the previous measure of risk. Is there a relevant one for me?
So why does all the advertising and PR say "Reduce risk by diversifying i don't know. more types of assets more fees?Is that just advertiser's bunk?actually no. although it is only one tool in the risk manager toolbox, it is useful in the sense that diversification helps avoid what is known as "gambler's ruin" which, in finance terms, is the one big bet that goes awry and wipes you out completely. in the parlance of your generation - "game over".note: diversification as taught in academia, primarily relates to diversification between types of financial assets - stocks bonds, cash, real estate, commodities. this type of diversification argument seems geared to reducing short term NAV volatility, which only makes sense if you are highly leveraged (which to be fair, most financial institutions are). but that type of diversification analysis is useless to unleveraged individuals managing their own net worth for long term results.for those individuals, with a longer term horizon, gambler's ruin arises primarily from the risk of a credit default or bankruptcy of the entity that they may be invested in. e.g. JM. there was a lot of "smart money" invested in Johns Manville, it was a "Dow stock" afterall. this type of risk can be managed with diversification within the same asset class.however, i do think, as i have stated in the Risk Arbitrage board, that diversification is overstated as a tool. even in the case of minimizing the impact of credit/default risk on a portfolio, the primary risk tool should still be proper due diligence. but due diligence does have it's limitations, dd is not going to protect you from fraud, nor would it have predicted what happened to P&G this past week. therefore i feel that some diversification is necessary. you can never know everything about any one thing, and the future is to a great extent unpredictable, therefore some type of diversification is necessary. tr
although it is only one tool in the risk manager toolbox, it is useful in the sense that diversification helps avoid what is known as "gambler's ruin" which, in finance terms, is the one big bet that goes awry and wipes you out completely. in the parlance of your generation - "game over".In one sense I'm exposed to gambler's ruin, having all my longterm investments in the S&P 500 (at least it's not the NASDAQ). But in another sense, even the complete destruction of that asset doesn't take away my other biggest financial asset: earning power.In short, I can afford a "gambler's ruin" scenario, so it's not something I have to avoid-at-all-costs. (I certainly WANT to avoid it, and if there's a way of doing it that won't limit my returns, I'd love to try it.)
i disagree. you are not exposed to gambler's ruin with a s&p index fund. in and of itself, that is a diversified investment approach. you are exposed to potential long term price volatility, as there are two instances in the 20th century where the s&p lost 75% of it's benchmark value in real (inflation adjusted) dollars, with total losses in the range of 45-65% with reinvested dividends.a s&p index fund, bought on margin to regulation t (50% equity), with a 25% equity maintenance level, exposes you to a margin call for a 25% pullback in the index.tr
I have been following the thread here on risk, and I would like to propose my concept of risk for your consideration.Essentially risk is about uncertainty. If you are certain (know everything) about a particular outcome, then there is no risk. On the other hand, if you are like most people that don't know everything (whether you admit it or not) then life is full of risks. Indeed, life is about the management of risk, not its elimination.Is volatility risk? Yes. The movement in the price of an asset creates uncertainty, therefore risk in the ultimate value of the asset on any given day. But, is risk embodied by volatility? No. Volatility is simply an element of risk.Is leverage risky? Yes. The use of leverage magnifies returns - both positive and negative. The magnification of a potential negative outcome certainly creates an element of risk.Is risk quantifiable? My opinion is no. You can "certainly" generate a number of statistics that attempt to measure risk - alpha, beta, gamma, etc. - but you can't measure risk with "certainty". Further, it is my opinion that risk is a relative concept, and at the end of the day, it is the individual that defines risk - in the context of his particular situation.Warren Buffett has said that you concentrate to create wealth, you diversify to protect wealth. Obviously, Warren feels that diversification mitigates risk. The great thing about a well thought out investment plan that is properly diversified, is that over time it can BOTH mitigate risk and increase wealth.The important thing here is to understand diversification and its impact on the risk you are willing to take regarding investments. The primary factor impacting your investment returns will be your choice of asset classes. Historically, returns have significantly increased as you moved up the food chain from money market instruments, to bonds, and ultimately stocks. If an investor makes the mistake of defining risk solely in the context of volatility - the choice is money market funds - even though historically, stocks have proven to be the superior investment.Thus, in my opinion, diversification within the proper asset class (stocks) is much more important to the long term investor than diversification among asset classes. How do you know when you have properly diversified your investments? When you understand everything that you have invested in, and can sleep at night without worrying about the day-to-day machinations of the market.My thoughts on the subject.Regards,Mark
I was pleased to find this board in my wanderings, but it now looks as though I must contribute in order to have something to read here.I was taught to understand risk through my losses. The lesson was good, as I now am growing into a position of greater and greater immunity from the vagaries of risk. I feel that the best protection against taking a hammering from high-risk investments gone awry is correct money management. We must develop the ability to absorb our losses instantly, and prepare for the next step on the road up.Risk is such a simple concept, and I can only agree with the previous poster who stated that life is about managing risk, not trying to eliminate it. When using the analysis of the probability of success or failure, and calling it risk, we must manage our money in a manner which allows for regular failure, but greater success. That is the challenge that drives the great speculators, greed drove the losers.
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