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Subject:  Re: Risk-Adjusted Returns: Relevant? Date:  2/23/2002  5:06 PM
Author:  solasis Number:  181 of 297

jrr7 you are asking good questions, and i'm not trying to be rhetorical by asking some back.

so, an extra year or two or 5 or 10 has no value to you? is that what you are saying? i agree that for most individual investors, who are investing for a specific goal (college for the kids, the european vacation, retirement etc) that the bumpiness of the road is less important than whether they meet their goal on time. and hence MPT is not very applicable. however, it is not clear to me why you think that a permanent impairment of capital can not be defined for your set of circumstances.

A 40% drop in the value of my portfolio this instant just means I need to work an additional year. It isn't permanent.

that may well be true if your current capital base is small relative to your future capital investments and provided your time horizon is long. but it is still zero sum in the sense that the 40% of your capital that is impaired may have let you meet your goals two years early, or as you say you will wind up missing your goal by one year. again, does that time not have value?

How does one know the probability of a large loss?

that's a difficult one. small probability but high consequence events are very difficult to manage. i prefer self insurance (a portion of net worth in tbills) in that regard.

if you do not understand the process that could impair your capital then it becomes difficult to define risk. this is what i consider the knightian uncertainty principle in its pure form.

fwiw, i disagree that it was not possible to see the risks in LTCM or Enron beforehand. in both cases there was a level of leverage or senior claims on capital that almost by definition made the junior equity in both situations high risk.

My point being that risk-adjusted returns are meaningless for me because they measure only volatility, which is an entirely different risk than the one I'm interested in.

if risk=short run price volatility (90 day) that might be true for a long significant time horizon and provided you are not leveraged (no senior claims on your capital employed). not true if you are entrusting your capital to someone else.

if risk=impairment of capital, then risk adjusted returns are important because impairment of capital risk is ubiquitous with all securities. for example, management at the business you are invested in could screw up and impair the company's capital, which in turn will impair the market price of your investment. inflation can seriously impair capital invested in a 10 year US treasury bond.

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