Defining Risk

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coachz
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Defining Risk

Post by coachz » Wed Oct 12, 2011 6:41 am

Are there any good articles that quantify risk in investing like a way to rate investments on the likelyhood of getting your principle back and the likelyhood of getting your expected profit ?

They seem to be two separate subjects. One, what is the chance I'll preserve my principle and Two, what is the chance I'll get my expected profit.

From all the so called experts out there, risk seems to be the one thing they have the most trouble explaining (besides their fees ! ).

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hand
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Post by hand » Wed Oct 12, 2011 6:57 am

You might be interested in this thread:

http://www.bogleheads.org/forum/viewtop ... 1318420470

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coachz
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Post by coachz » Wed Oct 12, 2011 7:10 am

Thanks. That was quaint but didn't actually quantify specific investments. That's what I'm looking for. Probably a books worth of material, not just a post though.

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Post by TN_INVEST » Wed Oct 12, 2011 7:56 am

There are all sorts of advance math stuff out there.

History shows that over time, investments form a tighter pattern whereas in shorter time periods the returns can be somewhat hit or miss. Let's say I was playing a game of poker against one of the leading players in the world. If we play just one hand, I might have a chance at getting lucky. However, the more hands we play, the more likely it is that the professional player will beat me (and yet, there is no absolute guarantee of this).


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Post by LadyGeek » Wed Oct 12, 2011 9:21 am

You could also try this thread: Redefining risk. There's 6 pages of material which goes into some depth (e.g. utility functions), and includes some rather "spirited" economist's opinions on the topic.
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Post by pkcrafter » Wed Oct 12, 2011 11:31 pm

Quaint? That's a description of risk definitions I've never heard before. Bobk did a good job of listing risk definitions, but as you've discovered, they don't help the average individual investor very much.
EDIT: descriptions of risk should have been attributed to poster Bobcat2, A.KA. Bobk

The reduction of risk over time only applies to standard deviation. The dispersion of the final total of a portfolio goes up over time.

Paul
Last edited by pkcrafter on Fri Oct 14, 2011 9:09 pm, edited 3 times in total.
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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Post by dbr » Thu Oct 13, 2011 8:37 am

One should note that the nature of risk in investing is both qualitatively and quantitatively different for different types of investments. Each needs to be studied separately. The best thing to do, in my opinion, is to start reading in basic books about investing with attention to discussion of risk in its various forms. If one book seems sketchy then additional reading needs to be sought. It is not uncommon for any given author to undertake discussion of risk without even mentioning that the discussion is limited to one particular aspect of the problem. More basic books often have more complete descriptions but not usually much quantification.

Within any given type of investment various distinctly different risks apply which are not commensurate. With bonds, for example, interest rate risk and default risk are completely different animals.

Probably the most studied forms of risk with the most detail are the variability of returns of equities and the behavior of bonds with respect to changes in interest rate. The former is semiempirical statistical problem and the latter is actually a quantitative relationship. Default risk of bonds is studied and quantified by bond rating, but that datum is not clearly related to a numerical chance of losing principal (or perhaps someone can supply a study that does do that -- it probably exists).

A different problem is finding data for a class of investments on average but trying to estimate numbers for a specific investment in the class. For example, understanding equity risk for an index fund of equities is different from estimating risk for a single stock. In that case the difference on average is the well known entity of diversifiable risk, but the estimate for a single stock is still essentially unknowable.

Another example is the often asked question of risks to stable value funds. Firstly, there are many types of stable value funds, but after that the problem is whether to rely on a history of problems with SV funds in general, and there are very few problems, or whether one should try to estimate how possible the single fund one is invested in might be subject to fraud or incompetence, an exercise that may be nearly impossible.

In any case, risk is linked to, or reflects, or is the manifestation of, uncertainty. By the very nature of the problem, information can only be gained and expressed through an understanding of statistical description of phenomena. As a result, the investor is going to have to be content to accept a result that is confined to the information that kind of description can provide.

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Post by coachz » Thu Oct 13, 2011 8:58 am

great reply. Can you recommend any books that do a good job of covering a wide variety of risks? Risk for Dummies ? Thanks for the very informative reply.

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Post by dbr » Thu Oct 13, 2011 9:09 am

coachz wrote:great reply. Can you recommend any books that do a good job of covering a wide variety of risks? Risk for Dummies ? Thanks for the very informative reply.
I'm not sure I have a finger tip on the best book for that subject exactly.

I can say the eye-openers for me in general would be

The Four Pillars of Investing by Bernstein

The entire series of all the books written by Larry Swedroe

All About Asset Allocation by Ferri

A Random Walk Down Wallstreet by Malkiel

Jim Otar's book here: http://www.retirementoptimizer.com/

The latter is especially helpful because it is an exhaustive and quantitative assessment of the risk of running out of money in retirement. That might be the single most relevant concept of risk for a retiree and that risk is NOT accessible by trying to estimate the properties of any single investment or class of investments.

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Re: Defining Risk

Post by TN_INVEST » Thu Oct 13, 2011 9:34 am

coachz wrote: risk seems to be the one thing they have the most trouble explaining

What Does Real Rate Of Return Mean?
The annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects.

Read more: http://www.investopedia.com/terms/r/rea ... z1afj2Dm1o


The real returns of stock is about twice that of bonds. The higher the real return, the more money you'll have. The more money you have, the less all that other stuff matters. :D

Your long term investments should be in stocks. You short term money should not. You have to put a pencil to it in order to determine how much money goes where.

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Post by LadyGeek » Fri Oct 14, 2011 1:37 pm

dbr wrote:
coachz wrote:great reply. Can you recommend any books that do a good job of covering a wide variety of risks? Risk for Dummies ? Thanks for the very informative reply.
I'm not sure I have a finger tip on the best book for that subject exactly.

I can say the eye-openers for me in general would be

The Four Pillars of Investing by Bernstein

The entire series of all the books written by Larry Swedroe

All About Asset Allocation by Ferri

A Random Walk Down Wallstreet by Malkiel

Jim Otar's book here: http://www.retirementoptimizer.com/

The latter is especially helpful because it is an exhaustive and quantitative assessment of the risk of running out of money in retirement. That might be the single most relevant concept of risk for a retiree and that risk is NOT accessible by trying to estimate the properties of any single investment or class of investments.
I was wondering the same thing and asked bobcat2 at the Bogleheads 10 convention. He suggested Finance by Zvi Bodie and Robert Merton, or Financial Economics (2nd Edition) if you want to pay $120 for the same book with a few new pages. (Amazon.com referral added to URL.)

It is is intended to teach the "fundamentals" rather than exclusively on corporate finance, which most texts do these days. There is a good risk section.
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Post by peter71 » Fri Oct 14, 2011 5:58 pm

LadyGeek wrote:
dbr wrote:
coachz wrote:great reply. Can you recommend any books that do a good job of covering a wide variety of risks? Risk for Dummies ? Thanks for the very informative reply.
I'm not sure I have a finger tip on the best book for that subject exactly.

I can say the eye-openers for me in general would be

The Four Pillars of Investing by Bernstein

The entire series of all the books written by Larry Swedroe

All About Asset Allocation by Ferri

A Random Walk Down Wallstreet by Malkiel

Jim Otar's book here: http://www.retirementoptimizer.com/

The latter is especially helpful because it is an exhaustive and quantitative assessment of the risk of running out of money in retirement. That might be the single most relevant concept of risk for a retiree and that risk is NOT accessible by trying to estimate the properties of any single investment or class of investments.
I was wondering the same thing and asked bobcat2 at the Bogleheads 10 convention. He suggested Finance by Zvi Bodie and Robert Merton, or Financial Economics (2nd Edition) if you want to pay $120 for the same book with a few new pages. (Amazon.com referral added to URL.)

It is is intended to teach the "fundamentals" rather than exclusively on corporate finance, which most texts do these days. There is a good risk section.
So has anyone actually read Bodie and Merton and do they have a fuller cite? Unlike many other econ textbooks (which tend to use the term fluidly) it's not searchable, and the below precis actually suggests even B&M concede it's "often associated with adversity and loss." If so, then I'm even less sure what BobK has been trying to persuade us of all these years . . .

http://www.ers.usda.gov/publications/aer774/aer774a.pdf

So is this a misquote of B&M? If so, pls refudiate!!!!! :D

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Post by bobcat2 » Fri Oct 14, 2011 8:32 pm

Here is the exact quote from the B&M first edition on the definition of risk.
Section 10.1 What is Risk?

We begin by distinguishing between uncertainty and risk. Uncertainty exists whenever one does not know for sure what will occur in the future. Risk is uncertainty that "matters" because it affects people's welfare. Thus, uncertainty is a necessary but not sufficient condition for risk. Every risky situation is uncertain, but there can be uncertainty without risk. ...
They then give examples that undergrads can relate to where there is uncertainty and no risk and uncertainty where there is risk. They go on.
In many risky situations, the possible outcomes can be classified either as losses or gains in a simple and direct way. For example, suppose that you invest in the stock market. If the value of your stock portfolio goes down, it is a loss, and if it goes up, it is a gain. People normally consider the "downside" possibility of of losses to be the risk, not the "upside" potential for a gain. But there are situations in which there is no obvious downside or upside. Indeed, [the earlier example of risk in] your planned party is an example. The uncertainty regarding the number of people who will attend your party creates risk whether more or fewer than the expected number of guests show up. Thus, in some situations deviations from the expected value can be undesirable or costly no matter which direction.
BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.

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Post by peter71 » Fri Oct 14, 2011 9:01 pm

Hi Bob,

Thx for the fuller cites . . . to me it sounds like they're saying that it's only in "some situations" that upside deviations are undesirable (and that they're stopping short of condemning "what people normally consider" when considering risk) but no doubt B&M do want students to consider a broader definition as well. Insofar as they (and you) are doing that in an ecumenical spirit, I'm all for it, but I also realize not everyone is ecumenical on these matters . . . anyone who teaches intro courses with boldfaced textbook terms and exams that include terminology has to make decisions about which definitions are sufficiently fixed such that students are forced to learn the correct definition and reproduce it on the test, and while I trust that many profs in my field are comfortable doing that with 95% or more of the terms in the textbook I'm personally more of a 65%'er . . .

Best,
Pete

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