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you have to define "risk", and each of us defines risk in a unique way. this is what martin whitman means when he says that risk is meaningless without an adjective in front of it.

for me,
capital risk = permanent impairment of invested capital.
permanent = a drop in the value of our capital that is unlikely to be regained within a significant time period at an estimated CAGR.
significant time period = 4-5 years.

you can plug any CAGR or time horizon you want into that definition and calculate a capital risk best suited for you. in the way i define capital risk, risk adjusted returns are paramount because impairment of capital detracts from your net worth. it is not something you surmount. it is an impairment.

for example, lets say i have a client with a cost of capital of 10%, and a time horizon of 5 years. for them a 40 % drop in value of capital invested is a permanent impairment because it can not be "made back" in 5 years at a CAGR of 10%.

LTCM and Enron clearly show why risk adjusted returns are important. risk adjusted returns are important because of ergodicity. as nicholas taleb points out in his book, he believes that most successful traders who blow up do not blow up "by accident", rather they did not have a viable approach in the first place. "they were merely deriving their income from the small probability of a large loss (up the escalator down the chute)" over a limited time span until ergodicity did them in.

you see the opposite effect in casinos where the equation is flipped upside/down (low probability of large gain). someone will come into the casino, hit it big early, then proceed to lose all of the gain and more as the statistical distribution reasserts itself with time.

more later.

tr
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