Risk - A Primer

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Risk - A Primer

Post by bobcat2 » Mon Oct 10, 2011 2:46 pm

Asset valuation and risk management are fundamental precepts of finance. But while asset valuation seems to be well understood by most investment enthusiasts, risk and risk management appear to be poorly understood by many investment enthusiasts. Before undertaking successful risk management, a solid understanding of risk itself is necessary.

The following is a brief primer on risk in economics and finance.

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In economics, including the subfield finance, there are at a minimum four aspects of risk that are central to understanding and using risk management techniques.

1) The definition of risk in economics
2) Specific risks
3) Measures of risk
4) The two components of risk


1) Definition of risk

Before defining risk we need to define the related term uncertainty.

Uncertainty simply means that we are not certain what will happen in the future.
or
Uncertainty means more than one outcome is possible.

The standard definition of risk in economics is straightforward.

Risk is uncertainty that affects people’s welfare, i.e. risk is uncertainty that is nontrivial.

Here is another way of expressing the definition of risk in economics.

A risky situation is a nontrivial situation where more than one outcome is possible.

Sometimes, particularly when discussing financial asset risk, we divide the uncertainty (risk) of the returns into two parts. The upside uncertainty is called opportunity or upside opportunity, and the downside uncertainty is called risk or downside risk.

Nearly 100 years ago economist Frank Knight formalized a distinction between risk and uncertainty. Knight’s method of separating risk and uncertainty is rarely used today. But when it is used, the terms are called “Knightian risk” and “Knightian uncertainty”.

Finally, the definition of risk in economics is neither a specific risk, nor is it a measure of risk.


2) Specific risks

There are many ways to classify risks but often in economics households are classified as being exposed to five major risk categories.
- Sickness, disability, and death
- Unemployment risk
- Consumer durable asset risk (damage to home, car, etc.)
- Liability risk
- Financial asset risk

When considering investments we are usually most concerned about financial asset risks. There are a multitude of specific financial asset risks. Consider the specific risks of investing in corporate bonds. At a minimum there is interest rate risk, inflation risk, credit risk, and reinvestment risk. The bond investor is exposed to all four of these risks. While each of these specific risks meets the definition of risk, none of them are the definition of risk, and none of them measure risk.


3) Measures of risk

There are many measures of risk when considering financial asset risk. Some common measures of financial asset risk are standard deviation (often called volatility), duration, beta, option pricing and option implied volatility, swap prices, and interest rate spreads to name just a few. Annual standard deviation (volatility) is the most common measure of asset return risk. Measures of risk always involve calculating a numerical value or set of values. The definition of risk has no numerical value(s) involved, and neither do specific risks.

Examples from other fields should clear up any confusion between risk measurement and specific risks and the definition of risk.

A Geiger counter measures levels of radioactivity. But Geiger counter readings are not the definition of radioactivity and they are not a specific risk of being exposed to high levels of radioactivity.

A blood pressure monitor measures blood pressure levels. But blood pressure readings are not the definition of blood pressure, nor are they a specific risk associated with abnormal blood pressure.


4) The two components of risk

Any risk has two elements, which are sometimes called the two components of risk.
i) the probability of the risk occurring
ii) the magnitude of the risk

Since neither component of risk is more important than the other, risk is the product of the two components of risk.

Risk = (Probability of risk) x (Magnitude of risk)

These two components of risk are not a definition of risk, but they are elements of every risk and we should prefer risk measures that take both risk components into account when assessing risk. This is one reason why standard deviation is a favored measure of financial asset return risk.

For example, we can calculate the annual standard deviation of the return from a portfolio. To calculate the risk of the portfolio for a single year we simply need, in addition to the standard deviation, the portfolio’s mean return, and the distribution of the return. We are then able to calculate both the probability and magnitude of the portfolio’s risk. For instance, if we estimate that the average portfolio return is 8% and the standard deviation is 10%, and the distribution of the return is normal, then there is about a 65% probability that the return will be between -2% and 18% next year. And there is about a 95% probability the return will be between -12% and 28% next year.

If there are no deposits or withdrawals from the portfolio then the standard deviation after (t) years is simply the square root of (t) times the annual standard deviation.
(t)^0.5 x (annual standard deviation).
In that case a similar analysis of risk to the annual analysis above can be performed.

If there are deposits or withdrawals affecting the portfolio the analysis becomes more difficult and simulation methods such as Monte Carlo are typically used, but standard deviation remains the key measure of risk in such simulation methods.


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: Risk - A Primer

Post by magician » Mon Oct 10, 2011 2:58 pm

Good write-up!
bobcat2 wrote:Consider the specific risks of investing in corporate bonds. At a minimum there is interest rate risk, inflation risk, credit risk, and reinvestment risk.
You might add default risk as a fifth, though many people would include that in credit risk. I tend to think of credit risk as the risk of downgrade, or the risk of spread widening, but not the risk of default per se.

There are many others, of course, but I'd argue that for corporate bonds default risk is as important as any of the four you enumerated.
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Post by bobcat2 » Mon Oct 10, 2011 3:33 pm

I had originally written default risk. But in checking this quickly the two places I looked before posting, they said credit risk, or what is the same thing, default risk. So I changed default risk to credit risk.

For instance at Wikipedia.
http://en.wikipedia.org/wiki/Credit_risk

In any event I'm sure there are other risks people can think of that corporate bond investors face. I was simply trying to point out that there are many particular risks - but none of them are the definition of risk. If people want to say that credit risk and default risk are two different risks, that's OK by me.

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Post by magician » Mon Oct 10, 2011 3:44 pm

bobcat2 wrote:For instance at Wikipedia.
http://en.wikipedia.org/wiki/Credit_risk
Thanks for the head's up. When I get a free moment, I'll fix the error in the Wikipedia article.

;)
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RISK

Post by efmoody » Mon Oct 10, 2011 4:35 pm

Standard deviation is not risk. It is a form of risk like many others, but is not risk ipso facto.

Standard deviation goes down over time. Therefore, so does risk????

Not a chance.

The dogma taught by universities has always been wrong. See Bodie Kane and Marcus for a more complewte treatise.

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Re: Risk - A Primer

Post by LadyGeek » Mon Oct 10, 2011 8:27 pm

bobcat2 wrote:1) Definition of risk
...
Here is another way of expressing the definition of risk in economics.

A risky situation is a nontrivial situation where more than one outcome is possible.

Sometimes, particularly when discussing financial asset risk, we divide the uncertainty (risk) of the returns into two parts. The upside uncertainty is called opportunity or upside opportunity, and the downside uncertainty is called risk or downside risk.

Nearly 100 years ago economist Frank Knight formalized a distinction between risk and uncertainty. Knight’s method of separating risk and uncertainty is rarely used today. But when it is used, the terms are called “Knightian risk” and “Knightian uncertainty”.

Finally, the definition of risk in economics is neither a specific risk, nor is it a measure of risk....
I'd like to append your signature to the end of (1), as it makes the most sense to me.

"In finance, risk is defined as uncertainty that is consequential (nontrivial)."

The last sentence is ambiguous, perhaps I can paraphrase a little:

"...Finally, the definition of risk in economics is neither a specific risk, nor is it a measure of risk; but simply defined as uncertainty that is consequential (nontrivial)."

Is Wikipedia a good reference for Knightian uncertainty?
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Post by Beagler » Mon Oct 10, 2011 8:52 pm

Serious question: How does one quantify the risk of TIPS' inflation index being switched to the Chain-weighted CPI?
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Post by pkcrafter » Mon Oct 10, 2011 9:31 pm

Thank you, Bob, what you've written does seem to cover the academic definition of risk, but here's the problem: Finally, the definition of risk in economics is neither a specific risk, nor is it a measure of risk.

Probably wrong, but I thought uncertainty was not classified as a definition of risk because it can't be measured. No matter, the problem is the definition(s) of risk are completely useless to the average investor.

Probabilities always remind me of this: the investor who loses 80% of his money is not impressed by the fact that he had only a 10% chance of losing this much money. For the average investor, the answer to risk is "you can lose this much." Probabilities are great unless you are the one on the short end of the stick.

Paul
Last edited by pkcrafter on Tue Oct 11, 2011 9:14 am, edited 1 time in total.
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Post by peter71 » Mon Oct 10, 2011 10:48 pm

pkcrafter wrote:Thank you, Bob, what you've written does seem to cover the academic definition of risk, but here's the problem: Finally, the definition of risk in economics is neither a specific risk, nor is it a measure of risk.
Academics use countless definitions of risk, and in fairness to Bob he's never suggested otherwise (though he does alternate in referencing economics in general and finance in particular).

If you really want to pursue the question of preferred definitions within the field, though, I think you need to look beyond this forum . . . a first step might be to search within the economics textbooks on Amazon and examine what, if anything, they say about definitions of risk.

http://www.amazon.com/s/ref=nb_sb_ss_i_ ... =economics+

Best,
Pete

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Re: RISK

Post by magician » Mon Oct 10, 2011 11:05 pm

efmoody wrote:Standard deviation goes down over time.
Perhaps annualized standard deviation (of returns) goes down over time, but total standard deviation of returns generally grows over time.

Think of it this way: if, starting with today = day 0, I hit you on the head with a brick only on prime number days, your average hits per day goes down over time, but over time you get hit with a lot more bricks.
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Economic textbooks definition of risk

Post by bobcat2 » Mon Oct 10, 2011 11:39 pm

If you really want to pursue the question of preferred definitions (of risk) within the field, though, I think you need to look beyond this forum . . . a first step might be to search within the economics textbooks on Amazon and examine what, if anything, they say about definitions of risk.

Definitions of risk from economic textbooks.

Risk is uncertainty that "matters" because it affects people's welfare.
Merton et al - Financial Economics

The term risk refers to the variability of the outcomes of some uncertain activity.
Nicholson - Microeconomic Theory

Risk is the uncertainty associated with the end-of-period value of an investment in either a single asset or a portfolio of assets.
Sharpe et al - Investments

Risk - the variability (or unpredictability) an asset contributes to a saver's real wealth.
Krugman et al - International Economics

The presence of risk means that more than one outcome is possible.
Bodie et al - Investments

Risk - The extent to which an investment is subject to uncertainty. Risk may be measured by standard deviation.
SBBI 2005 edition

I believe what I call the standard definition of risk in economics is perfectly consistent with these above textbook definitions of risk. In fact reading these is where I got the definition, which is only a slight rewording of one of the above definitions. But notice they all give essentially the same definition and 3 of the texts were written by Nobel Prize winners.
...he does alternate in referencing economics in general and finance in particular.
Not a problem. As I noted in the OP finance is a sub-field of economics, formally known as financial economics.

Here is what this boils down to -
In economics risk and uncertainty are the same thing. But if you say that some wise guy in the back of the room will bring up a trivial uncertainty and point out that in that case no risk is involved. So the caveat that the uncertainty has to be consequential (nontrivial), or as Merton puts it - "matters" by affecting people's welfare, needs to be added to the definition.

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 » Tue Oct 11, 2011 7:38 am

Hi Bob,

That's an interesting assortment of some subfield textbooks and a "valuations yearbook", but what stood out for me is that the usage appears entirely informal in the three top-selling and searchable general textbooks:

Mankiew:

http://www.amazon.com/Principles-Econom ... 782&sr=8-3

Hubbard and Obrien:

http://www.amazon.com/Economics-3rd-R-G ... 782&sr=8-9

Baumol and Blinder:

http://www.amazon.com/Economics-Princip ... 82&sr=8-16

Now, obviously the introductory textbooks are going to be the highest sellers, but it's nonetheless interesting to me that these Harvard, Columbia, NYU and Princeton profs feel comfortable introducing their field without any formal "primer" on defining risk. Instead, they seem happy to use the term rather informally and in a panoply of contexts . . .

Best,
Pete

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Post by magician » Tue Oct 11, 2011 8:23 am

peter71 wrote:Now, obviously the introductory textbooks are going to be the highest sellers, but it's nonetheless interesting to me that these Harvard, Columbia, NYU and Princeton profs feel comfortable introducing their field without any formal "primer" on defining risk. Instead, they seem happy to use the term rather informally and in a panoply of contexts . . . .
That's not all that different from mathematics texts - some of them quite advanced - that omit a formal definition of a set. The idea is fundamental, but an informal understanding is sufficient for most contexts, and a formal definition (and the attendant explanation) would be extremely cumbersome and tangential; i.e., wouldn't contribute to a better understanding of the topic at hand.
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Re: Economic textbooks definition of risk

Post by magician » Tue Oct 11, 2011 8:29 am

bobcat2 wrote: Definitions of risk from economic textbooks.

Risk is uncertainty that "matters" because it affects people's welfare.
Merton et al - Financial Economics

The term risk refers to the variability of the outcomes of some uncertain activity.
Nicholson - Microeconomic Theory

Risk is the uncertainty associated with the end-of-period value of an investment in either a single asset or a portfolio of assets.
Sharpe et al - Investments

Risk - the variability (or unpredictability) an asset contributes to a saver's real wealth.
Krugman et al - International Economics

The presence of risk means that more than one outcome is possible.
Bodie et al - Investments

Risk - The extent to which an investment is subject to uncertainty. Risk may be measured by standard deviation.
SBBI 2005 edition

I believe what I call the standard definition of risk in economics is perfectly consistent with these above textbook definitions of risk. In fact reading these is where I got the definition, which is only a slight rewording of one of the above definitions. But notice they all give essentially the same definition and 3 of the texts were written by Nobel Prize winners.
A common definition of risk in project management is:

An uncertain event or condition that, should it occur, has a positive or negative effect on a project's objectives
PMBOK® Guide, 3rd edition

This, too, is consistent with the definition you've proposed.
Simplify the complicated side; don't complify the simplicated side.

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Post by bobcat2 » Tue Oct 11, 2011 8:39 am

Hi Pete,

I am not surprised that in intro textbooks risk is not defined. Risk and uncertainty are fairly advanced areas of economics and their treatment at the intro level is fairly superficial. For that reason I didn't even look at intro textbooks for definitions of risk.

What's interesting about the definition of risk in the six books I listed as it is essentially the same in all the books. And why shouldn't it be, otherwise economics would be a modern day Tower of Babel problem when it comes to discussing risk.

BobK
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Post by peter71 » Tue Oct 11, 2011 8:42 am

magician wrote:
peter71 wrote:Now, obviously the introductory textbooks are going to be the highest sellers, but it's nonetheless interesting to me that these Harvard, Columbia, NYU and Princeton profs feel comfortable introducing their field without any formal "primer" on defining risk. Instead, they seem happy to use the term rather informally and in a panoply of contexts . . . .
That's not all that different from mathematics texts - some of them quite advanced - that omit a formal definition of a set. The idea is fundamental, but an informal understanding is sufficient for most contexts, and a formal definition (and the attendant explanation) would be extremely cumbersome and tangential; i.e., wouldn't contribute to a better understanding of the topic at hand.
Hi Magician,

I guess the fundamental question is whether any of this matters to Bogleheads . . . in many fields, including both medicine and behavioral sciences that estimate "hazard models" of undesirable events, risk often carries a negative connotation . . . and I think the reason that Bob doesn't like that is that it's much easier to argue that stocks will have uncertain prospects over the long term than that they will have either a) absolutely bad prospects over the long term or b) that they will have relatively worse propsects than bonds . . . but to me this is all just a semantic detour in that one can't settle whether stocks are good or bad by definitional fiat.
Instead, what economists like Siegel and Stambaugh are arguing about (or, actually, agreeing upon, though others don't agree with them) is that stock valuations tend to mean revert . . . if that's the case, then all the Norstad-type deductive modelling where stocks regularly return 3 SD's above or below the mean for 30+ years is all the more problematic.

Best,
Pete

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Post by magician » Tue Oct 11, 2011 9:07 am

peter71 wrote:Hi Magician,

I guess the fundamental question is whether any of this matters to Bogleheads . . . .
Hi back atcha, Pete!

As you probably know, there have been several, shall we say, lively threads discussing risk on this forum, so it appears that it matters to some Bogleheads; whether or not it should is another matter entirely.

;)
peter71 wrote:Instead, what economists like Siegel and Stambaugh are arguing about (or, actually, agreeing upon, though others don't agree with them) is that stock valuations tend to mean revert . . . .
Do they argue that stock valuations revert to [a] mean, or that stock returns revert to [a] mean? The latter's OK (so long as the mean's above some positive threshold); the former's probably not.
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Post by peter71 » Tue Oct 11, 2011 9:31 am

Hi Magician,

Well, we then circle back to the question of what aspect of risk is of interest to people posting about it, and I suspect the possibility of adverse outcomes (i.e., disutility) is of concern to many . . .

On what it is that mean reverts, however, I am indeed betraying my own bias that valuations enter the mix, and it would have been more accurate to say that, "perhaps due to investor attention to valuations, Siegel and Stambaugh agree that RETURNS mean revert over time."

http://knowledge.wharton.upenn.edu/arti ... cleid=2229

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Pete

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"Utility" the same as "welfare" and repr

Post by VictoriaF » Tue Oct 11, 2011 10:33 am

bobcat2 wrote:1) Definition of risk

Risk is uncertainty that affects people’s welfare, i.e. risk is uncertainty that is nontrivial.
...
Sometimes, particularly when discussing financial asset risk, we divide the uncertainty (risk) of the returns into two parts. The upside uncertainty is called opportunity or upside opportunity, and the downside uncertainty is called risk or downside risk.
Hi Bob,

Thank you for the primer. I highlighted (bold+underline) a few concepts that I would like to get clarification on. In economics there is a concept of utility:
- Can welfare be used interchangeably with utility in the context of the definition of risk?
- Can we consider the upside uncertainty a gain in utility, and the downside uncertainty a loss in utility?

Please comment.
bobcat2 wrote: ...
Nearly 100 years ago economist Frank Knight formalized a distinction between risk and uncertainty. Knight’s method of separating risk and uncertainty is rarely used today. But when it is used, the terms are called “Knightian risk” and “Knightian uncertainty”.
As I understand it:
- The distinction is that “Knightian risk” quantifiable and “Knightian uncertainty”is not?
- And the distinction is not used, because even with the normal (Gaussian) distribution, there is no "certainty" (as in "epsilon is not zero")?
bobcat2 wrote: ...
4) The two components of risk

Any risk has two elements, which are sometimes called the two components of risk.
i) the probability of the risk occurring
ii) the magnitude of the risk

Since neither component of risk is more important than the other, risk is the product of the two components of risk.

Risk = (Probability of risk) x (Magnitude of risk)
Putting probabilities aside, can the second component of risk be presented as:
ii) the magnitude of the lost utility
?

Thanks!

Victoria
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Re: Risk - A Primer

Post by grayfox » Tue Oct 11, 2011 11:17 am

bobcat2 wrote:
If there are no deposits or withdrawals from the portfolio then the standard deviation after (t) years is simply the square root of (t) times the annual standard deviation.
(t)^0.5 x (annual standard deviation).
In that case a similar analysis of risk to the annual analysis above can be performed.
Not to be nit-picky, but isn't standard deviation after (t) years = (annual standard deviation) / (t)^0.5, because the s.d. goes down over time? Or maybe I am misunderstanding.

Also 68-95-99.7

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Re: Risk - A Primer

Post by magician » Tue Oct 11, 2011 12:08 pm

grayfox wrote:
bobcat2 wrote:
If there are no deposits or withdrawals from the portfolio then the standard deviation after (t) years is simply the square root of (t) times the annual standard deviation.
(t)^0.5 x (annual standard deviation).
In that case a similar analysis of risk to the annual analysis above can be performed.
Not to be nit-picky, but isn't standard deviation after (t) years = (annual standard deviation) / (t)^0.5, because the s.d. goes down over time? Or maybe I am misunderstanding.
Annual standard deviation of returns tends to decline over time, but total standard deviation of returns increases over time. bobcat2 has the formula correct.
grayfox wrote:Also 68-95-99.7
Come again?
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SD

Post by efmoody » Tue Oct 11, 2011 7:52 pm

C'mon guys- it isn't that hard

SD over time is the annual SD DIVIDED by the square root of the number of years.

Consumers however want to know how mcuh they can lose.

One minus the SD for the number of years to the power of the number of years gives the amount that is left after a one SD movement based on a simple Gaussian curve.

Over course it requires other subjective input. As for the validity of SD as risk- read the comments by Buffet and Munger.

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Re: Risk - A Primer

Post by VictoriaF » Tue Oct 11, 2011 8:05 pm

magician wrote:
grayfox wrote:Also 68-95-99.7
Come again?
Here is a reference to the 68-95-99.7 rule,

Victoria
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Re: Economic textbooks definition of risk

Post by LadyGeek » Tue Oct 11, 2011 8:17 pm

bobcat2 wrote:...Risk is uncertainty that "matters" because it affects people's welfare. - Merton et al - Financial Economics

Risk is the uncertainty associated with the end-of-period value of an investment in either a single asset or a portfolio of assets. Sharpe et al - Investments

Risk - the variability (or unpredictability) an asset contributes to a saver's real wealth. Krugman et al - International Economics
...
I believe what I call the standard definition of risk in economics is perfectly consistent with these above textbook definitions of risk. In fact reading these is where I got the definition, which is only a slight rewording of one of the above definitions. But notice they all give essentially the same definition and 3 of the texts were written by Nobel Prize winners.
One minor correction. There is no "Nobel Prize" in economics. It's the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Taleb (The Black Swan) had quite a bit to say about this, but that's for another thread.

(Please keep the thread focused on risk, I just wanted to point this out.)
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Re: Economic textbooks definition of risk

Post by VictoriaF » Tue Oct 11, 2011 8:53 pm

LadyGeek wrote:
bobcat2 wrote:But notice they all give essentially the same definition and 3 of the texts were written by Nobel Prize winners.
One minor correction. There is no "Nobel Prize" in economics. It's the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
Hi LadyGeek,

Bob has referred to the correct name of the prize many times. In this case, he used a shorthand.

See you tomorrow,

Victoria
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Re: Risk - A Primer

Post by magician » Tue Oct 11, 2011 8:55 pm

VictoriaF wrote:
magician wrote:
grayfox wrote:Also 68-95-99.7
Come again?
Here is a reference to the 68-95-99.7 rule,

Victoria
Thanks. Never heard anyone refer to it before.
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Post by LH » Wed Oct 12, 2011 12:37 am

Beagler wrote:Serious question: How does one quantify the risk of TIPS' inflation index being switched to the Chain-weighted CPI?


Been waiting for this one to occur.

In general, quantifying uncertainty is a real trick : )

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Re: Risk - A Primer

Post by grayfox » Wed Oct 12, 2011 1:10 am

magician wrote:
grayfox wrote:
bobcat2 wrote:
If there are no deposits or withdrawals from the portfolio then the standard deviation after (t) years is simply the square root of (t) times the annual standard deviation.
(t)^0.5 x (annual standard deviation).
In that case a similar analysis of risk to the annual analysis above can be performed.
Not to be nit-picky, but isn't standard deviation after (t) years = (annual standard deviation) / (t)^0.5, because the s.d. goes down over time? Or maybe I am misunderstanding.
Annual standard deviation of returns tends to decline over time, but total standard deviation of returns increases over time. bobcat2 has the formula correct.
OK, I think I understand.

1. The s.d. of annualized returns goes down over time, sd1/sqrt(n). E.g. after 16-years the s.d. would be 1/4 of the 1-year s.d.

2. But the s.d. of the whole n-year return goes up over time, sd1*sqrt(n). e.g. s.d. 16-year returns is 4x larger than than the s.d. of 1-year returns. The dispersion gets larger over time.

I did not know the formula for that second part. (Or maybe I once knew it and forget it. It's worthwhile reviewing this stuff periodically.) But it makes sense, maybe. Actually, it's pretty cool that both formulas end up being so simple, just divide or multiply by sqrt(n).

I also found a tutorial here on the subject
http://www.gummy-stuff.org/square-root-time.htm
also
http://www.gummy-stuff.org/SD-stuff.htm

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TIPS and chained CPI

Post by bobcat2 » Wed Oct 12, 2011 6:34 am

LH wrote:
Beagler wrote:Serious question: How does one quantify the risk of TIPS' inflation index being switched to the Chain-weighted CPI?


Been waiting for this one to occur.

In general, quantifying uncertainty is a real trick : )
Actually I don't think this one is that hard. I PM'd my response to Beagler, because I didn't want the thread to get sidetracked on a discussion of this minor risk. Here is most of the PM.

I would use the two components of risk directly.
Pick my subjective probability of the risk occurring and multiply it by 25 basis points (roughly the historical average of the difference between the CPI and the chained CPI). I would also make a forecast of when I thought the switch might first occur and only start the risk there.


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 nisiprius » Wed Oct 12, 2011 6:40 am

This looks like a Bogleheads Wiki article to me. In due course, if nobody either beats me to it or objects strenuously, I'll believe I'll put it in, linking to this post and identifying it as bobcat2's work.

In Wikipedia itself, the procedure is just to be bold and put stuff in, relying on the give and take of further editors to hash down to a a stable form--typically by including and identifying and fairly treating divergent opinions. The Bogleheads Wiki doesn't really have enough contributors to count on that working and I'm not completely sure I understand the authority structure, so I thought I'd kind of float the idea here first.

I'm thinking the title should not be "A Primer on Risk" but "Risk as understood in economics" or "Definition of risk in economics" or "Economic definition of risk."
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Re: Economic textbooks definition of risk

Post by nisiprius » Wed Oct 12, 2011 6:54 am

VictoriaF wrote:
LadyGeek wrote:
bobcat2 wrote:But notice they all give essentially the same definition and 3 of the texts were written by Nobel Prize winners.
One minor correction. There is no "Nobel Prize" in economics. It's the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel.
Hi LadyGeek,

Bob has referred to the correct name of the prize many times. In this case, he used a shorthand.

See you tomorrow,

Victoria
Let me add that I think it's absurd to insist on using the full form. One might as well insist on calling RI The State of Rhode Island and Providence Plantations." If it's important to signal the nice distinction, one might follow the lead of http://www.nobelprize.org/nobel_prizes/ ... omination/ and call the winners "Laureates in Economic Sciences" and somehow avoid using the phrase "Nobel Prize." But it doesn't really matter. There isn't any other comparable prestigious prize in economics and the distinction only gets trotted out when someone wants to knock some specific laureate in Economics, or criticize economics itself.

We all know the Peace Prize and the Prize in Literature ain't really the same as the others, even though they are authentic Nobel Prizes. For all I know, cognoscenti who know what goes on behind the scenes might be able to point out subtle differences in the objectivity of (say) Medicine and Physics.

Meanwhile, they all get superficially identical-looking 5-Troy-ounce if I've done the math right gold medal, suitable for framing, and enough Kronor to qualify for Flagship status at Vanguard.
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Post by LadyGeek » Wed Oct 12, 2011 8:39 am

nisiprius wrote:This looks like a Bogleheads Wiki article to me. In due course, if nobody either beats me to it or objects strenuously, I'll believe I'll put it in, linking to this post and identifying it as bobcat2's work.

In Wikipedia itself, the procedure is just to be bold and put stuff in, relying on the give and take of further editors to hash down to a a stable form--typically by including and identifying and fairly treating divergent opinions. The Bogleheads Wiki doesn't really have enough contributors to count on that working and I'm not completely sure I understand the authority structure, so I thought I'd kind of float the idea here first.

I'm thinking the title should not be "A Primer on Risk" but "Risk as understood in economics" or "Definition of risk in economics" or "Economic definition of risk."
That's the plan. Bobcat2 gave me a starting outline a while ago (via PM, as he's not a wiki editor), but it got put on hold. The articles are categorized as "development" and flagged as "work in progress." Any or all of this content is open for revision or reorganization, including renaming articles.

I created a Portfolio Risk management category to group the articles. Start here: Category:Portfolio risk management

Wiki article link: Investment risk management

Wiki article link: Portfolio risk versus returns: the statistics (I took a stab at this, but it's more a collection of notes and may not convey what Bobcat2 intends. It will probably be rewritten - no big deal.)

My Nobel prize comment was triggered from reading Taleb's Black Swan, who is one of VIctoriaF's favorite authors. I'll discuss it with her at Boglehead's 10, no need to continue here.
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Post by peter71 » Wed Oct 12, 2011 9:06 am

While there's very little at stake here, I guess I object to the idea that "risk as understood in economics" is any more fixed than it is in the four top-selling econ textbooks I linked to above. It would at a minimum be nice to have at least a couple of academic economists on the forum weigh in and say, "the intro textbooks are being overly informal, the vast majority of economists use the term "risk" not as do the intro textbooks, but precisely as Bob (and his selection of subfield textbooks and non-textbooks) suggests . . ."

Best,
Pete

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Post by Valuethinker » Thu Oct 13, 2011 3:56 am

bobcat2 wrote:I had originally written default risk. But in checking this quickly the two places I looked before posting, they said credit risk, or what is the same thing, default risk. So I changed default risk to credit risk.

For instance at Wikipedia.
http://en.wikipedia.org/wiki/Credit_risk

In any event I'm sure there are other risks people can think of that corporate bond investors face. I was simply trying to point out that there are many particular risks - but none of them are the definition of risk. If people want to say that credit risk and default risk are two different risks, that's OK by me.

BobK
It might be

default risk = probability of default

credit risk = broader risk arising from credit difficulties ie including restructuring of distressed businesses that never actually default, but conversely also

default net of expected recovery

Most corporate bonds when they default, there are some proceeds available to bond holders. They seldom drop to zero (financial institutions might be an exception-- after the depositors or policyholders are paid out, subordinated debt usually gets very little, and could get zero).

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