"how to measure risk?"

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JohnFiscal
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"how to measure risk?"

Post by JohnFiscal »

I know there must be dozens (hundreds) of threads here about "risk", and I'm sure there are as many websites that go into this as well. And I'm familiar with concepts such as alpha and beta, credit risk, currency risk, etc. But I would like to get a grasp on the "risk" of my portfolio. Is there some "simple" method of assessing portfolio risk?
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Re: "how to measure risk?"

Post by Rodc »

You may very well lose 50% of your stock value over a short time period. Might even be more. They will likely bounce back over a similar span of time, but may take many years (maybe never though if this is true of the global market probably you are in deep trouble no matter what you do). If you need to sell to generate cash in that period you are going to lose a lot of money.

Nominal bonds may lose that amount (in purchasing power) over decades and take that long to recover. At least this is a slow deflate so easier to replan and regroup if this happens.

TIPS if you can hold them to maturity will not lose purchasing power. But you might not be able to hold them to maturity due to job loss etc, but even still likely the choice with the least likelihood of real loss. Typically not going to make a lot either.

I would also add that you need to decide what risk means to you and choose a measure that aligns with that definition. A tenured professor will perhaps have different risks in mind than a commission-based salesman.
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Re: "how to measure risk?"

Post by nisiprius »

I use two numbers. The one I really like is "percentage of decline from 12/31/2007 to 3/2009" because that is how I experience the kind of risk that poses a behavioral problem for me.

A lot of sophisticates will pooh-pooh this is "oh, that's just drawdown risk" and imply it's not the risk you should care about. Well, I care about it a lot.

For example, here we see that Total Stock (VTSMX, blue) was risky; that contrary to beliefs about "dividend stocks being safer in a bear market," Vanguard High DIvidend Yield (VHDYX, orange) was just about as risky; that Total Bond (VBMF, green) was not very risky at all; and that the typical target retirement funds and stock allocations recommended for 50-year-olds--in this case Fidelity Freedom 2020, FFFDX, yellow--are only slightly less risky than a pure stock fund.

Source: Morningstar
Image

More scientific, but less useful, are the 15-year standard deviation numbers which you can find at Morningstar under the "Ratings and Risk" tab, as well as the Sharpe ratio, which measures risk-adjusted return. In my opinion small differences in either of these numbers aren't meaningful.
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Re: "how to measure risk?"

Post by richard »

There are many statistics, some of which are very simplified measures (standard deviation and its variants, such as Sharpe ratio), some of which are sophisticated (multi-factor models which endeavor to measure risk and return). Most are backward looking, such as the most US stocks have lost in any one year period over the past 90 or so years.

A prominent finance expert has said risk is the chance of your portfolio doing badly in bad times. This is a definition, not a quantification. It may well be the case that there is not good generally applicable number representing risk.

However, none of these measures are helpful if they're not meaningful to you. It really comes down to what is a risk for you.
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Re: "how to measure risk?"

Post by staythecourse »

In the end the BEST description I have heard of risk is from Mr. Gibson of "Asset Allocation". He describes, after it is all said and done, there are only two real risks: In the short run (volatility) and in the long run (shortfall risk/ inflation risk). The key to understanding investing is that anytime you choose one product it may protect you from one risk, but by its virtue it increases your other risk. Thus there is no way to protect for both risks.

MM, CD's, ultrashort term bonds, savings accounts decreases volatility, but increases inflation risk especially if one considers the effect of taxes onto the investment. Stocks of course have HUGE volatility, but decreases shortfall risk.

So what is an investor to do? The only logical approach is to make sure you have enough savings/ investments to protect you from volatility which is the main short term risk for ALL investors. For example: If you have a need of 60k of living expenses AND have 40k of debt per year then you better have 100k of investments dedicated to protecting against volatility. If you are retired then ALL of that coverage has to come from investments. If you are working then some of it can be covered by you paycheck. Mr. Clement had a very useful % to use for debt to income ratio.

That is the only sensible way to make one's asset allocation decisions modified a bit for investor psychology if one needs to be more conservative. Randomly choosing "I like 60/40 or 80/20" is not a reasonable approach.

The one exception to the above is TIPS that seem to protect on both above risks, so not sure what to think of that. Would love to hear what Mr. Gibson thinks of that.

Good luck.
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Re: "how to measure risk?"

Post by JohnFiscal »

Thank you all for the comments. Quite useful.

I realize my question sounds naïve, and likely is. :)

But as I am within only a few years (2-4) of retiring this sort of thing weighs on me more. I would hate to be one of those people who retires and then there is the market crash losing 50%. Of course, no measure of risk is going to tell us when that market crash will occur, right?! But I don't want to be too greedy at this stage of my life and I need some sort of reality check.

Behaviorally, I have never been prone to selling when the market is down, or crashing. I viewed 1989 as a "blue light special" sale. And even in the dot com crash of early (whenever that was) and the 2008 debacle I didn't consider selling. In fact, I bought into the down market after 2008 with a smallish lump sum for a particular account, and wish I had bought in with some of the large cash reserve I'd had on the sideline.

I know that I can review my funds' volatility rank in Morningstar (and other sources). And from the viewpoint of "squinting and sighting down my outstretched thumb" I know that there is the risk that the Dow might drop from its current 17,000+ back down to the 7,000 it was at only a few years ago, and possibly even lower. And then there is the risk that if there were such a drop it could take like 25 years to recover, as I seem to remember some such statistic about the Dow's low after the 1929 crash and that it took until the 1950's to get back to its high. Those are all "visceral" measurements of risk, not the academic measurement.

I plugged in my retirement portfolio into the money.cnn portfolio tool and it tells me that my beta is "1.0" (same risk as S&P 500) when I do not include my large cash reserve, and the beta is only 0.8 when I include the cash. So I think this gives me some reassurance.

Yes, I have a large cash reserve. Almost embarrassing to have such a large reserve, but I don't know what else to do with it, I'm not going to stick it into stocks, and I am a bit leery of bond funds. I guess that is the next thing to study and resolve, but then having that large cash reserve has been quite reassuring to me over the past 8 years.
Last edited by JohnFiscal on Wed Feb 04, 2015 1:29 pm, edited 1 time in total.
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Re: "how to measure risk?"

Post by staythecourse »

JohnFiscal wrote:Yes, I have a large cash reserve. Almost embarrassing to have such a large reserve, but I don't know what else to do with it, I'm not going to stick it into stocks, and I am a bit leery of bond funds. I guess that is the next thing to study and resolve, but then having that large cash reserve has been quite reassuring to me over the past 8 years.
I think that is the low hanging fruit for you to focus on in your situation. Why not just put it into a CD ladder for 5-10 yrs. Or at least max out Ibonds and EE Bonds. Or start buying TIPS. If you are in high taxable Vanguard even has a short term tax exempt (duration around 1 yr) that allows you to write check from it.

There are MANY options then just leaving the money in the bank that does not add much extra principle volatility to that wad of cash.

Good luck.
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Re: "how to measure risk?"

Post by bobcat2 »

How to measure portfolio risk.

Portfolio risk (uncertainty) is typically measured by annual standard deviation (SD). This measure of risk is often called volatility. Its value is usually found either by taking the standard deviation (SD) of annual returns or annualizing the SD of monthly returns. Since stocks are riskier than fixed income, particularly if you ladder fixed income as you approach retirement, we are mainly concerned with equity risk when assessing portfolio risk. This volatility measure for the US stock market is usually about 20%.

It’s important to realize that the above volatility measure of 20% is a long-term average measure of stock market risk. It is a constant over the period measured. One thing we know about risk is that over time risk is not constant. Market risk varies greatly over time. Measures of daily volatility (daily SD) are usually below average, sometimes about average, and in a few instances well above average. Market volatility usually doesn't change on a dime. That's why periods of high market risk are known as episodes of "volatility clustering." Unusually large market moves in either direction tend to be followed by additional large market moves in either direction. The same goes for unusually small market moves in either direction and typical market moves in either direction.

Daily volatility is typically measured by option pricing models such as the VIX or by GARCH statistical models. In both cases the daily values are annualized to be consistent with the annual SD measure of volatility. It's important to note that the VIX and GARCH estimates of daily volatility give very similar results although the methods are quite different.

Volatility has a zero absolute lower bound and a practical lower bound of about 8% or 9%. There is no upper bound and the VIX reached a peak of about 80% in 2008. In other words the distribution of risk is skewed right. LT average daily volatility is about the same 20% as annual volatility measured as annual standard deviation over decades. (Which is what should be happening. :D ) But the above noted skewness in volatility means daily median volatility is less than average daily volatility. Median daily volatility is about 17%-18%. Thus a VIX daily average of 30% or more for an extended period of days is way above the median.

If you look at the VIX over roughly the last 20 years or GARCH estimates over that same time period you see the same thing. Mainly periods where daily volatility is below the mean, some periods where volatility is near the mean, and a few volatility clusters, usually lasting several months, where volatility is typically well above the mean. Those periods of volatility clustering are almost always associated with market downturns, usually significant downturns. Don't take my word for it. Look at the the CBOE VIX graphs or the GARCH estimate graphs at the NYU Volatility Lab! See the links below.

Why shouldn't the above be the case? The volatility being high is simply recording the obvious about risk. At some points in time there is much more uncertainty or risk in the market and the economy than there usually is. Wasn't there more uncertainty in 2000 after it became apparent that many dot.com companies had seen their market values rise very fast even though they were reporting no earnings and very little revenues. In the third trimester of 2001, wasn't there much more uncertainty than usual in financial markets and the economy in the aftermath of the 9/11 attacks? In October of 2008 wasn't there much more market uncertainty than usual when it appeared several major banks might go belly up? In late 2008 and early 2009 wasn't there much more market uncertainty than usual when it appeared AIG and major US automakers might go belly up? Given the economic and financial uncertainty at the time what is surprising about the VIX reaching approximately 80% in November of 2008?

High volatility clusters are unusual and reflect much higher than normal uncertainty (risk) in the equity market going forward in the near term, i.e. the next several months. Typically a high volatility cluster will last at least several months and possibly as long as 2 years or more in rare instances.

The GARCH estimate of volatility at the NYU Volatility Lab shows that volatility has rarely been above 20% at any time in the last three years and is currently about 17%.

Check it out here
http://www.stern.nyu.edu/experience-ste ... -institute

and here
http://vlab.stern.nyu.edu/

The VIX measure of the same thing is currently also about 17% and it too shows hardly any out of the ordinary volatility since late 2012.

Look here for the current VIX value and check out the different price charts at the bottom of the page for the VIX graphs going back as far as 10 years.
https://www.cboe.com/micro/vix/pricecharts.aspx

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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Re: "how to measure risk?"

Post by CyberBob »

Staythecourse posted a great answer. The Roger Gibson idea that risk is a continuum with volatility at one end and shortfall risk/inflation at the other. And you can't escape risk. Moving away from one just exposes you more to the other. You've just got to get happy somewhere in the middle.

Warren Buffett has an interesting view on risk. Unlike most definitions you'll find, he comes down more on the shortfall/inflation side of things.
(See Berkshire Hathaway 2011 Shareholder Lettter, page 16, "The Basic Choices for Investors and the One We Strongly Prefer" [PDF]).
The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.

Investments that are denominated in a given currency include money-market funds, bonds, mortgages,bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”

For tax-paying investors like you and me, the picture has been far worse. During the same 47-year period, continuous rolling of U.S. Treasury bills produced 5.7% annually. That sounds satisfactory. But if an individual investor paid personal income taxes at a rate averaging 25%, this 5.7% return would have yielded nothing in the way of real income. This investor’s visible income tax would have stripped him of 1.4 points of the stated yield, and the invisible inflation tax would have devoured the remaining 4.3 points. It’s noteworthy that the implicit inflation “tax” was more than triple the explicit income tax that our investor probably thought of as his main burden. “In God We Trust” may be imprinted on our currency, but the hand that activates our government’s printing press has been all too human.

Today, a wry comment that Wall Streeter Shelby Cullom Davis made long ago seems apt: “Bonds promoted as offering risk-free returns are now priced to deliver return-free risk.”
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Re: "how to measure risk?"

Post by nisiprius »

Thanks for a useful contribution, Bobcat2. Hasn't the VIX ever been back-calculated over a long period of time, though, so that we would get a real long-term overview?

I have to say that I believe "risk" is a subjective thing and that there is not any "correct" way to measure it. When Cass Sunstein wrote
The year was 2011. The stock market was recovering well from its terrible collapse during the Great Recession, but over a short period it had a series of stumbles. I got nervous. What if it collapsed again?

At the time, I was working in the federal government, with a daughter in college, a 2-year-old boy and a new child on the way. Could I afford to lose a lot of money? Wouldn’t it make sense to sell equities and to put the money into a safe, reliable certificate of deposit?

...Seeing a decline in the fund’s value, I decided to sell a significant chunk. I e-mailed Richard Thaler, the great behavioral economist and my co-author on "Nudge," and before proceeding, I asked him whether I would be making a mistake.

His response: “Reread our book!”

I pretty much knew what he meant, but that was a bit vague for me (our book is long), so I proceeded as planned and sold that significant chunk. Giving Thaler the news, he exclaimed, “No! 'Nudge' explains that you shouldn’t have done that!”
Where do VIX or standard deviation play into that decision?

(By the way, I think Sunstein draws exactly the wrong conclusion, which is in essence is "I should have been tougher than I was, everyone else should be tougher than I was, and next time I will be tougher than I was.")
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Re: "how to measure risk?"

Post by JohnFiscal »

Some more interesting concepts!

For myself, I am not averse to volatility. I think some volatility is good and useful. To draw an analogy, I am reminded of one time driving a 2-lane interstate northbound from Minneapolis in very light rain. There was heavy traffic and some few people wanted to drive miserably slow, which they did in both lanes. This blocked the drivers who wanted to drive faster, and could do so safely, from doing so. Consequently, drivers were typically driving up on each other's bumpers at 50 mph, not a safe situation IMO. If some "volatility" had been added, through the provision of a passing lane enabling those who wished to do so to pass then things would have been much more productive and safer all around. In my mind this same concept applies to market volatility.

What I am averse to is losing a big enough chunk of my portfolio to have lasting effects (or "permanent" in the sense it being of my lifetime).

And this, it seems, is where wise asset allocation comes in.
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Re: "how to measure risk?"

Post by knpstr »

JohnFiscal wrote: What I am averse to is losing a big enough chunk of my portfolio to have lasting effects (or "permanent" in the sense it being of my lifetime).

And this, it seems, is where wise asset allocation comes in.
I agree.

At a younger age the only risk is likely panicking and selling low during a bust, since over time the bust is likely to "correct" and having the time available to wait it out there is little risk (except for behavioral again). Again, if you have the time available, volatility isn't a big risk for funds you aren't touching for 30 years.

At an older age the risk of volatility is more "real" since you're actively drawing down your portfolio and may be "forced" to sell low. This is where asset allocation comes into play having other funds available to draw from other than the "crashed" asset.
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Re: "how to measure risk?"

Post by galeno »

Two portfolio risks: shallow (volatility) mitigated by fixed income and deep (inflation)j mitigated by equities and TIPS.
KISS & STC.
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Re: "how to measure risk?"

Post by knpstr »

staythecourse wrote: Randomly choosing "I like 60/40 or 80/20" is not a reasonable approach.
I think this is key, I'm not a fan of general rules of thumb such as "your age in bonds" or the standard ratios you've mentioned. living expenses to nest egg size it what matters. I absolutely agree that your short term expenses need to be guarded from volatility. Whether this is your age, 20% or 60% depends on your funds available to divvy up.
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Re: "how to measure risk?"

Post by richard »

Two portfolio risks: shallow (volatility) mitigated by fixed income and deep (inflation)j mitigated by equities and TIPS.
There have been a few posts to this effect.

Where does (1) equities drop by a large amount and stay there or (2) equities fail to rise while dividends fall, fit in? Neither case is really volatility (certainly not the second) and neither is necessarily due to inflation and neither is impossible.
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Re: "how to measure risk?"

Post by staythecourse »

richard wrote:
Two portfolio risks: shallow (volatility) mitigated by fixed income and deep (inflation)j mitigated by equities and TIPS.
There have been a few posts to this effect.

Where does (1) equities drop by a large amount and stay there or (2) equities fail to rise while dividends fall, fit in? Neither case is really volatility (certainly not the second) and neither is necessarily due to inflation and neither is impossible.
When has the global equity market gone down and stayed down? The answer is never. It can't happen if society is to continue as most of the world is capitalistic, i.e. those who provide the capital are the ones who profit. If you supplied the capital and never made money then NO ONE would supply capital and nothing would be done in the world of business. Business throughout the world would come to slow halt.

The mistake many think is there is somewhere safe to hide if equities are done for a long time. The answer is there isn't. DFA had a GREAT presentation linked by
?Robert T using Dimson and Marsh 101 yrs. of worldwide equity returns in a post about a year ago or so. If one looked at the worst stretch of equity returns in history for any country and took the worst 5-6 (which the presentation did) it indeed showed huge losses if one was 100% in that equity market. What folks didn't realize is it showed that the real returns were worse AND time to recover were worse for that country's bonds and cash during the same time periods.

So if equities hit the dumps you are still better holding it then the same country's bonds or cash markets. Very much different then the gut feeling investors have about a long, prolong equity disaster.

Good luck.

p.s. This FAITH in equity markets and what they represent is why Mr. Buffett and Mr. Bogle, for example, are such excellent investors. NO matter what the current climate is they have an unflinching faith in the world of commerce and that as a society we will always be moving forward no matter how many speed bumps occur long the way.
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Re: "how to measure risk?"

Post by itstoomuch »

Which is why we have religion. :annoyed
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Re: "how to measure risk?"

Post by richard »

We barely have 90 years of more or less reliable market data. An investing lifetime is in excess of 30 years for the vast majority. That means we have three independent data points. Hardly a good basis for predicting the future with a high degree of confidence.

10 year treasuries recently hit their all time high price, low yield. Plainly this was impossible, as it never happened before.

Japan's equity markets that have been in the doldrums for a very long time. Society and capitalism seem to be functioning nonetheless. In fact, Japan has very low unemployment (well under US and Europe) and a high standard of living.

Capitalism does not imply a rising equity market. The relation between risk and expected return is much closer to a principle of capitalism.

Equities have returned more than bonds because they are riskier. If they are guaranteed to outperform bonds over the long-term, they are not riskier.
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Re: "how to measure risk?"

Post by knpstr »

richard wrote: Equities have returned more than bonds because they are riskier. If they are guaranteed to outperform bonds over the long-term, they are not riskier.
Well don't equities essentially pay for bond returns?

Equities are corporations and bonds are corporate debt. If the corporation wants to stay running it needs to be able to meet it's debt obligations and then some. They must outperform bonds over the long term, if not, there won't be businesses to issue bonds.

As far as faith matters I think it is a no-brainer to bet that we keep improving as a global society. If it all goes to the crapper we are going to have larger fish to fry than worrying about our retirement accounts.
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Re: "how to measure risk?"

Post by JohnFiscal »

I liked staythecourse's comments but, Richard, you present a good argument too. The "black swan" event. And who knows, maybe there could be a whole flock of them.

But I guess the answer is still in a good asset allocation plan. And not get into too much outré investment strategies...not listening to cold calls (a la' "Wolf of Wall Street").

Mostly, I'm just wondering if I should hold on to my large positions in LLPFX, VPMAX, and VGHAX or drain them into the VTSAX and VTIAX index funds. But that's for another thread.
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Re: "how to measure risk?"

Post by Johno »

staythecourse wrote:
richard wrote:
Two portfolio risks: shallow (volatility) mitigated by fixed income and deep (inflation)j mitigated by equities and TIPS.
There have been a few posts to this effect.

Where does (1) equities drop by a large amount and stay there or (2) equities fail to rise while dividends fall, fit in? Neither case is really volatility (certainly not the second) and neither is necessarily due to inflation and neither is impossible.
When has the global equity market gone down and stayed down? The answer is never.

p.s. This FAITH in equity markets and what they represent is why Mr. Buffett and Mr. Bogle, for example, are such excellent investors.
I would add that it's a bit of mismatch to talk about how it's 'impossible' for *global* equities to go down and stay down, then end up to appealing to the authority of a highly successful (indeterminate combination of skill and luck) investor who says to put all your risk in the US, and the founder of a great investment firm who grudgingly at best acknowledges the validity of diversifying globally. However 'impossible' it is for global equities to perform poorly over a prolonged period, it would seem less impossible for that to happen in one (albeit the largest cap, also now more richly valued than most; Japan was both those things ca. 1989 btw), national stock market.

More generally the point is that the risk of inadequacy of long term return isn't limited to low risk assets, and pointing that out should not be mistaken for a statement that low risk assets will necessarily have adequate returns in cases where higher risk assets do not. Also, stocks and bonds aren't the only assets. Real estate for example might be an asset which provides genuine diversification away from the equity risk premium, to some degree at least, especially in direct (not REIT, that is) form. It might not be suitable for everyone though. So is there a place to hide so to speak if equity returns are poor for a long period? Not necessarily.

Also besides the serious matter of degree between 'equity returns are poor for a long period' and 'businesses make no profits' it's also necessary to remember that there's plenty of room for slippage between the performance of business assets in general and stocks. Consider for example if perhaps well intentioned but perhaps misguided increases in regulation cause more business assets to be held privately. There's no guarantee that a proportional amount of profit and value will then show up in publicly traded assets. As an albeit extreme example, consider China which has been minting new billionaires at a startling pace as its economy has grown many fold in a period of a few decades, but the return of the domestic stock index over the period is poor. Anyway the American Century is not necessarily the template for the future, either in the world or even in the US. And it's not a question of American Century II or total world meltdown, get the canned food and guns! That's a sort of straw man that really should be banished from these discussions. Anyway the view from the top, the US as we've known it on top, the history that men like Buffett and Bogle have lived (and they also typify some of the reasons for that national success) naturally forms their view. Unfortunately there's no gtee the future will be like the past. And saying 'impossible' about the future is a big red flag in anyone's argument about anything, to me anyway.
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Re: "how to measure risk?"

Post by lack_ey »

richard wrote:We barely have 90 years of more or less reliable market data. An investing lifetime is in excess of 30 years for the vast majority. That means we have three independent data points. Hardly a good basis for predicting the future with a high degree of confidence.[...]
I'd say the data is far from independent, even if you partition the time series into non-overlapping segments.

It's one thing to have statistical models showing different probabilities of events occurring. Let's say you were told that stocks could have negative nominal returns in the next twenty years with a probability of 0.05, or some such. How would you respond? The problem in finance is that nobody can guarantee the accuracy of the model in the first place, so there are further layers of uncertainties.
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Re: "how to measure risk?"

Post by Rodc »

lack_ey wrote:
richard wrote:We barely have 90 years of more or less reliable market data. An investing lifetime is in excess of 30 years for the vast majority. That means we have three independent data points. Hardly a good basis for predicting the future with a high degree of confidence.[...]
I'd say the data is far from independent, even if you partition the time series into non-overlapping segments.

It's one thing to have statistical models showing different probabilities of events occurring. Let's say you were told that stocks could have negative nominal returns in the next twenty years with a probability of 0.05, or some such. How would you respond? The problem in finance is that nobody can guarantee the accuracy of the model in the first place, so there are further layers of uncertainties.
He says it is bad. You say it is worse.

Let's change it to say we have at best three independent data points and call it a day...

Either way it ain't much data to hang a hat on.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
SirHorace
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Re: "how to measure risk?"

Post by SirHorace »

I’m with nisiprius on this issue. I have been playing around with trying to develop a visual metric for evaluating risk. A preliminary example is below. I have calculated the drawdown characteristics of the 45 Fidelity sector funds (enumerated below). Seven of the funds showed drawdowns in excess of 80% of which I have shown 5 in the chart (four of the 45 funds did not have sufficient data to plot in the time frame selected).

In terms of risk factors, the chart shows the relative speed and time duration in which a fund recovers a significant loss. I would certainly rather have a fund with FSAVX (Automotive) recovery characteristics as opposed to recovery characteristics of FSVLX (Consumer Finance) for example.

Image

(Chart downloaded with tinypic.com)

Chart extracted from drawdown characteristics of the 45 Fidelity Sector Funds enumerated below, except as noted.

1 FBIOX Biotechnology
2 FBMPX Multimedia
3 FBSOX IT Services
4 FCVSX Convertable Securities
5 FCYIX Industrials
6 FDCPX Computers
7 FDFAX Consumer Staples
8 FDLSX Leisure
9 FFGCX Global Commodity Stock (Insufficient Data)
10 FIDSX Financial Services
11 FIREX International Real Estate (Insufficient Data)
12 FIUIX Telecom and Utilities
13 FNARX Natural Resources
14 FPHAX Pharmaceuticals (Insufficient Data)
15 FRESX Real Estate Investment Portfolio
16 FRIFX Real Estate Income (Insufficient Data)
17 FSAGX Gold
18 FSAIX Air Transportation
19 FSAVX Automotive
20 FSCGX Industrial Equipment
21 FSCHX Chemicals
22 FSCPX Consumer Discretionary
23 FSCSX Software and Computer Services
24 FSDAX Defense and Aerospace
25 FSDCX Communications Equipment
26 FSDPX Materials
27 FSELX Electronics
28 FSENX Energy
29 FSESX Energy Service
30 FSHCX Medical Delivery
31 FSHOX Construction and Housing
32 FSLBX Brokerage and Investment Mgmt
33 FSLEX Environment & Alternative Energy
34 FSMEX Medical Equipment and Systems
35 FSNGX Natural Gas
36 FSPCX Insurance
37 FSPHX Health Care
38 FSPTX Technology
39 FSRBX Banking
40 FSRFX Transportation
41 FSRPX Retailing
42 FSTCX Telecommunications
43 FSUTX Utilities
44 FSVLX Consumer Finance
45 FWRLX Wireless

SirHorace
itstoomuch
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Re: "how to measure risk?"

Post by itstoomuch »

I like to imagine "Risk Premium"

Suppose year 0, you have a total stock portfolio. It has returned in year 0 a total of 8% yoy. You wish to derisk your portfolio, so yo decide on a 50:50 (total stock:total bond).
Then in year 1, the total stock yielded 8% and the total bond yielded 2%.
So at the end of year 1, the blended yield is 5%. The Risk Premium for moving half of funds to bonds is -6%. The loss returns are -37% if you kept to the 100% stock.

Put some numbers to this: I used portfolio=200,000 and then split that into 100,000 stock and 100,000 bond.

YMMV.
Each person has their own risk tolerance. :oops:
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robert88
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Re: "how to measure risk?"

Post by robert88 »

staythecourse wrote: When has the global equity market gone down and stayed down? The answer is never.
The two fundamentals in economic growth are population growth and productivity growth. For various reasons, people in the developed world and some parts of the developing world(China and Russia) aren't having enough children to replace the population. I expect the world population to eventually peak and then enter a slow, gradual decline. I'm more bullish on productivity growth, but historically technology, other than military weaponry, didn't change much from the fall of the Roman Empire to the Revolutionary War, so you had a 1000+ year period with annualized productivity growth near zero.
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Re: "how to measure risk?"

Post by staythecourse »

robert88 wrote:
staythecourse wrote: When has the global equity market gone down and stayed down? The answer is never.
The two fundamentals in economic growth are population growth and productivity growth. For various reasons, people in the developed world and some parts of the developing world(China and Russia) aren't having enough children to replace the population. I expect the world population to eventually peak and then enter a slow, gradual decline. I'm more bullish on productivity growth, but historically technology, other than military weaponry, didn't change much from the fall of the Roman Empire to the Revolutionary War, so you had a 1000+ year period with annualized productivity growth near zero.
It is all opinion, but I can bet if there is an incentive (no better then money) countries will spur on population growth with incentives. Policy decisions at the government level are always made to benefit the country. If they need more workers they will incentive citizens to have more children. Simple as that.

Also, a link on the comment of 1000+ yrs. of no productivity would be useful as that is quite the statement to make.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle
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Re: "how to measure risk?"

Post by 4nursebee »

I'm not sure how to quantify or describe portfolio risk, neither do I really care.

There are several excellent books available that discuss how to adjust ones portfolio based upon the risk (or volatility) of an asset class. These books are not geared for a BH type crowd, more so for Hedge Funds, traders, and the ilk. But I think that the principles these texts teach regarding volatility could equally well be applied to long term buy and holder similar to BH.

The simple ideas in these books suggest small ownership of volatile/risky assets and larger ownership of less volatile asset classes.
If you read the books you will get an idea of how to quantify the riskiness of an asset class, along with an idea of how much of it might be safe to own based upon personal tolerances. The aid of a computerized trading platform would assist in this.

The books to read would include most any thing by Van Tharp, Michael Covel, or anything about the start of the Turtle Trading program.
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Re: "how to measure risk?"

Post by Johno »

staythecourse wrote:
robert88 wrote:I'm more bullish on productivity growth, but historically technology, other than military weaponry, didn't change much from the fall of the Roman Empire to the Revolutionary War, so you had a 1000+ year period with annualized productivity growth near zero.
Also, a link on the comment of 1000+ yrs. of no productivity would be useful as that is quite the statement to make.
Here's a link with different estimates of world GDP per capita some back to the time of early hominids (pp 5-6). By one series, output per person sank back to the prehistoric level around 1300, and was never more than double the prehistoric level until around 1800, but 33 times higher in 2000 than 1800. The very old estimates and any exact numbers are of course subject to debate, but I don't think there's much debate that per capita output was essentially static for multi-century periods prior to the industrial revolution.
http://delong.typepad.com/print/20061012_LRWGDP.pdf

More broadly, could there be an issue here with actually thinking probabilistically? Everyone speaks of 'risk' but it seems many people's actual mode of thought is to consider various future possibilities, but then choose the one they think most likely (or they just like the most) and proceed as if that's now become 'the answer'. Faith was mentioned before, it does seem kind of like that, but I don't think faith has a place in investing, personally. I think there's a real possibility the returns machine of the last century largely shuts down, but much further discussion of why I entertain that possibility would probably lead to the usual heavy handed moderating. But anyway that's alongside what I believe is the probably greater possibility that the stock graph of the next several decades looks mainly like the last century (up, down, underlying uptrend something like similar, 3% real?, 8% real? something like that). I don't have to choose a scenario and dig in my heals defending it. But I can't see a basis to state as if certainly that 'stocks will always do best'. As was said, if that's true, they aren't really risky.
Tanelorn
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Re: "how to measure risk?"

Post by Tanelorn »

Risk is the chance that someone whose opinion you care about can afford more stuff than you can down the road.
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Re: "how to measure risk?"

Post by bobcat2 »

staythecourse wrote: When has the global equity market gone down and stayed down? The answer is never. It can't happen if society is to continue as most of the world is capitalistic, i.e. those who provide the capital are the ones who profit.
Myth meet reality.
From the point of view of a US investor, who is invested in the global equity market in US dollars, the global portfolio has not gone down and stayed down for an extended period. That same global portfolio has gone down and stayed down for very long periods for investors in several other countries because of real exchange rate volatility. For example, when global stock index returns are expressed in German currency (marks and later euros) they reveal that a German global investor would have had to wait 57 years to achieve a positive real return. Global investors in the world index from Italy and Japan would have needed to wait 33 and 34 years to achieve a positive real return. Going forward investors in all countries are exposed to this risk of long-term negative real returns from global investing brought about at least in part by exchange rate volatility.

Link to source - Irrational Optimism by Elroy Dimson, Paul Marsh, and Mike Staunton - See page 11
https://faculty.fuqua.duke.edu/~charvey ... timism.pdf

From the abstract of the paper.
Although the probable rewards from equity investment are attractive, stocks did not and cannot offer a guaranteed superior performance over the investment horizon of most investors. Furthermore, their prospective returns are lower than many investors project, whereas their risk is higher than many investors appreciate. Investors who assume that favorable equity returns can be relied on in the long term or that stocks are safe so long as they are held for 20 years are optimists. Their optimism is irrational.
BobK

PS - There is no loyalty premium in equity investing. You don't get rewarded for being faithful in the long-run to your stock portfolio. :)
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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Re: "how to measure risk?"

Post by kolea »

nisiprius wrote:I use two numbers. The one I really like is "percentage of decline from 12/31/2007 to 3/2009" because that is how I experience the kind of risk that poses a behavioral problem for me.
Yes! I do exactly the same thing. When I am looking at something I may want to invest in, the first thing I ask is what did it do in the crash of 2008?

The trouble with beta and standard deviation is that those are measures of total volatility, which includes lots of high frequency variations that you probably do not care about. The two biggest risks I care about are: (1) market crashes, and (2) inflation. I do what nisiprius does to assess (1), and (2) is not something that one sleuths out with metrics or charts, but rather needing to understand how the asset responds to inflation.

Other than market crashes, I do not put a lot of concern on volatility. It is given and I just try to work with it.
Kolea (pron. ko-lay-uh). Golden plover.
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knpstr
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Re: "how to measure risk?"

Post by knpstr »

JohnFiscal wrote:Is there some "simple" method of assessing portfolio risk?
No. :D
Very little is needed to make a happy life; it is all within yourself, in your way of thinking. -Marcus Aurelius
staythecourse
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Re: "how to measure risk?"

Post by staythecourse »

bobcat2 wrote:Myth meet reality.From the point of view of a US investor, who is invested in the global equity market in US dollars, the global portfolio has not gone down and stayed down for an extended period. That same global portfolio has gone down and stayed down for very long periods for investors in several other countries because of real exchange rate volatility. For example, when global stock index returns are expressed in German currency (marks and later euros) they reveal that a German global investor would have had to wait 57 years to achieve a positive real return. Global investors in the world index from Italy and Japan would have needed to wait 33 and 34 years to achieve a positive real return. Going forward investors in all countries are exposed to this risk of long-term negative real returns from global investing brought about at least in part by exchange rate volatility.
Just curious if you know how the investors in Germany, Italy, and Japan did during those same time periods if they would have been in the "safe" cash and bonds of their respective countries? I remember data showing the worst 5 equity runs in history and those 5 countries during those stretches had a quicker recovery and less total REAL losses then if those same investors would have been parked in their cash and/ or bond components. What I took from that is even if the chance did happen equity returns hit the tank for a long record setting period you were no better, and in many ways worse, then just being in stocks vs. fixed income.

Good luck.
"The stock market [fluctuation], therefore, is noise. A giant distraction from the business of investing.” | -Jack Bogle
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Re: "how to measure risk?"

Post by pkcrafter »

Bobk wrote:
Myth meet reality.
From the point of view of a US investor, who is invested in the global equity market in US dollars, the global portfolio has not gone down and stayed down for an extended period. That same global portfolio has gone down and stayed down for very long periods for investors in several other countries because of real exchange rate volatility. For example, when global stock index returns are expressed in German currency (marks and later euros) they reveal that a German global investor would have had to wait 57 years to achieve a positive real return. Global investors in the world index from Italy and Japan would have needed to wait 33 and 34 years to achieve a positive real return. Going forward investors in all countries are exposed to this risk of long-term negative real returns from global investing brought about at least in part by exchange rate volatility.

Link to source - Irrational Optimism by Elroy Dimson, Paul Marsh, and Mike Staunton - See page 11
https://faculty.fuqua.duke.edu/~charvey ... timism.pdf

BobK

PS - There is no loyalty premium in equity investing. You don't get rewarded for being faithful in the long-run to your stock portfolio.
An excellent post, Bob. You've made it very clear, risk IS risky in the short term, in the long term!

Paul
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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Re: "how to measure risk?"

Post by abuss368 »

For us it is easy: How much can we afford to lose or be up at night worrying!
John C. Bogle: “Simplicity is the master key to financial success."
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