Wiki - Investment Risk (revised for new investors)

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sat Apr 07, 2012 6:31 pm

Here's a sentence that seems pretty clear to me without getting into much detail:

Although expected return is the best estimate available of future returns, the actual return is not likely to equal the expected return.


This is the first sentence of what looks to me like a good article on risk and return, although it's much more advanced than our basic article. Here's the link: http://ci.columbia.edu/ci/premba_test/c ... /s6_4.html

Also, it may be useful to see this, which was included in an earlier version of our basic article. It was to set up the subsequent sections, but since we moved most of that material to the "advanced" article we're working on now, it was removed:

Even though this definition of risk sounds simple, questions arise:

  • How is uncertainty of returns (risk) evaluated and measured for different types of investments?
  • What is "expected rate of return", and how is it evaluated?
  • What can be done to manage risk?
  • How does an investor factor risk into investment decisions?
  • Are there differences between short-term risk and long-term risk?
  • The definition above does not distinguish between positive and negative outcomes. Isn't risk just the possibility that the investor will lose money on the investment?


You can see that the second and last items specifically address the issue of the definition of "expected return" and the concept that risk is not just considered "the possibility of loss" in portfolio theory.

I'm still thinking adding a couple of paragraphs to the intro could clear up some of the concerns, at least for those who think the article is basically OK, but needs some tweaking to add clarity.

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 12:36 am

Feedback from four very novice investors I asked to review the article (folks who are unlikely to even visit Bogleheads):

Three of four mentioned that the charts in Figure 1 were not easy to understand, and that that section in general was the most difficult. The fourth person did not mention the charts, said it was good, and useful to read, and only had a problem with the discussion of systematic risk, but said the definition cleared it up for her.

None mentioned any confusion about expected returns.

Sharing this to encourage others to share their thoughts if they find the charts or anything else difficult to understand. Please don't be shy.

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 6:34 am

The charts in Figure 1 of the intro to risk and return article were really intended to build up to the understanding of dispersion of returns, variance, and standard deviation. Most of that was cut from this article and moved to the more advanced article. Therefore, I'm coming to the conclusion that we just need a simpler chart to get the point across about the relationship between range (uncertainty) of returns and average (expected) returns.

Below is a wee-hours-of-the-morning drawing of the chart I have in mind. Please consider the concept, and don't laugh too hard at my feeble attempt at drawing.
Image
Advantages:

  • One chart instead of three.
  • I think that most people intuitively think of the vertical axis as magnitude. Histograms aren't as intuitive to understand.
  • Only three vertical lines; one for each asset class
  • Average returns clearly increase from left to right
  • Range of returns clearly increases from left to right

The exact details of the chart are not important, just the main idea: show range of returns on the vertical axis, use one line for each asset class, and indicate averages with horizontal ticks on each vertical line.

Also, wording along the lines that LadyGeek suggested upthread may be more appropriate for this level, and I think would work well with this simpler chart.

I will be getting feedback on this from my small sample of novice investors. What do you think?

(The charts in figure 1 in the current version of the intro article will be used in the more advanced article, because it is intended for those who want to get slightly into textbook-level understanding without having to read a textbook. For those of you who easily understand the charts in Figure 1, perhaps you are ready for the more advanced article.)

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 7:36 am

Modified to make increasing risk (uncertainty) and return more clear:

Image
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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Sun Apr 08, 2012 9:51 am

I don't know about people not experienced in math, but when I see two axes, I expect each to be labelled as having some meaning. I wonder if the x-axis label should not be risk, while the labels bills, bonds, and stocks are point labels, as they are. The term to use for the span of the outcome might not be risk but volatilty or dispersion or uncertainty.

There is a subtle philosophical point here that risk is not defined as volatility but rather one of the properties or implications of volatility is being risky. An analogy is that walking too close to the edge of a cliff is not a definition of risk but rather that walking to close to the edge of a cliff has the property or result of being risky. The actual definition of risk is something else, such as there being a possibility that something bad might happen.

This also gets us away from the hang up that risk in investing is defined as the SD, while actually SD is simply a measure of volatility and we consider volatility to be risky. Why do we consider volatility to be risky? One reason is that volatility implies the possibility that one can lose money from one time to another, depending on how volatile compared to the average gain. SD is one statistic we can calculate from volatility and probability of loss is another. Neither, per se, is a definition of risk but rather both are properties that we think of as being risky. Another reason volatility results in risk is that it defeats our ability to predict the outcome, which then makes it difficult to plan. That is one reason upside volatility is as risky as downside volatility. It implies that we might strain to earn too much and sacrifice to save too much when it will turn out we didn't need to. That is also a bad thing and therefore has the property of being risky.

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Re: Wiki - Investment Risk (revised for new investors)

Post by bob90245 » Sun Apr 08, 2012 9:56 am

Kevin M wrote:Modified to make increasing risk (uncertainty) and return more clear:

Image

Your title of "Average Returns" is misleading. Yes you do have the horizontal hash marks for average returns. But the vertical lines represent "Range of Annual Returns".

As you describe in the text, the return in any one year as been as high as X and as low as Y. A range that is wider means there is more risk.

Oops! On second reading, I see that "Average Returns" is not the title of the chart but points to the horizontal hash marks.

I'm afraid if I made a mistake of reading the chart, there must be others who did the same. Go back and see if you can make things more clear...
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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Sun Apr 08, 2012 10:07 am

bob90245 wrote:Your title of "Average Returns" is misleading. Yes you do have the horizontal hash marks for average returns. But the vertical lines represent "Range of Annual Returns".

As you describe in the text, the return in any one year as been as high as X and as low as Y. A range that is wider means there is more risk.

Oops! On second reading, I see that "Average Returns" is not the title of the chart but points to the horizontal hash marks.

I'm afraid if I made a mistake of reading the chart, there must be others who did the same. Go back and see if you can make things more clear...



It is so easy for a person who has practiced experimental science to understand reporting of results with error bars to follow this and so difficult to find a way to explain the concept to people who have not experienced how this works. (This does NOT mean Bob). I think the present issue is entirely typographical and can be fixed up in time. I sometimes volunteer in sixth grade science classrooms and make every effort to bring the concept to the attention of students working on science projects. I don't think I got to really understand what was going on until they introduced propagation of errors in my freshman level physics lab.

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Re: Wiki - Investment Risk (revised for new investors)

Post by LadyGeek » Sun Apr 08, 2012 11:15 am

I used the same data file and created a new chart.

Image
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Re: Wiki - Investment Risk (revised for new investors)

Post by bob90245 » Sun Apr 08, 2012 11:48 am

LadyGeek wrote:I used the same data file and created a new chart.

Image

Much, much better!
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 1:14 pm

Beautiful LadyGeek! Like I said, my chart was just the basic idea :idea: drawn by someone crazy enough to do this kind of thing in the wee hours of the morning (which for me is really late at night).

Feedback so far from two novice investors, but who have been reading my blog and have heard me talk about this stuff, is that the new chart idea is easy to understand and gets the idea across well. Note that this feedback is from two of the folks I "surveyed" about the article, but who have not yet given feedback on the article overall.

I love the graph! Very straightforward and easy to read. Great work!

I really like this chart ... Definitely easy to understand and a very good visual for people like me to understand the relationship between returns and risk!


We can wait for more feedback if we want, but I think I'm ready to just replace the charts in Figure 1 with this one, and update the text to something more along the lines of LadyGeek's suggestion (although we will do some collaborating on it I'm sure :wink: ). We also need to make sure any references to Figure 1 that relied on the old charts are reworded appropriately.

I won't have time today (hopefully most of us won't!), but LG and/or Barry, feel free to tackle it any time if you can get to it.

In rewording, I'd still like to keep the focus on uncertainty as risk, not just as "you might lose money", since although the latter is important, and we can mention it, the intent is to take the reader to the next level of understanding risk in the context of portfolio theory, in which it has the non-intuitive meaning that applies as much to upside surprises as downside surprises--not all the way, just a baby step in that direction.

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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Sun Apr 08, 2012 1:57 pm

Kevin M wrote:
In rewording, I'd still like to keep the focus on uncertainty as risk, not just as "you might lose money", since although the latter is important, and we can mention it, the intent is to take the reader to the next level of understanding risk in the context of portfolio theory, in which it has the non-intuitive meaning that applies as much to upside surprises as downside surprises--not all the way, just a baby step in that direction.

Kevin


Just draw a red line at zero and shade the part below as "Here be dragons, ie you just lost money." You can also point out that all of that range that isn't on the average hash mark is where what you got isn't what you planned, the half below being shortfall and the half above being windfall. I don't like this mystification that uncertainty fails to include danger when in fact uncertainty is exactly why there is danger.

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Re: Wiki - Investment Risk (revised for new investors)

Post by bob90245 » Sun Apr 08, 2012 2:14 pm

bob90245 wrote:
LadyGeek wrote:I used the same data file and created a new chart.

Image

Much, much better!

Actually, I came up with an idea to make this chart even clearer.

1) Remove the extra vertical bar that is labeled "Risk"

2) Underneath the skinny part of the lower dashed line on the left, write "Less Risk"

3) Underneath the wide part of the lower dashed line on the right, write "More Risk"

4) Then you can make a connecting solid double-arrow pointing to "Less Risk and "More Risk" in parallel and below the lower dashed line. This implies the possibility of a continuous range of risk and can be further explained in Part 2.
Last edited by bob90245 on Sun Apr 08, 2012 2:18 pm, edited 1 time in total.
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 2:17 pm

Thoughts on revised intro to address many of the concerns that have been raised. This is a paraphrased version of the next "improvement" I have in mind.

  • This (current) definition applies to portfolio theory. Note that it does not distinguish between loss and gain, does not mention time frame, and does not consider the investment goal.
  • Typical individual investors think of risk as the possibility that their investments could lose money. Cite Rick Ferri, "All About Asset Allocation" (2006), p.23 (Rick has enough experience with individual investors to be a credible source). They are likely to be quite happy with an investment return that is greater than expected.
  • In financial planning, the investment goal must be considered when defining risk. If the goal of the investment is to fund retirement, then risk is the possibility that the investor will outlive the investment portfolio. (Liability matching, without using the term; or use the term if we think it won't be confusing)
  • Maybe define "expected return" using the wording I quoted upthread " expected return is the best estimate available of future returns". It seems understandable (to me), yet accurate without referencing statistical terms or any math.
  • This article focuses on the definition of risk as used in portfolio theory (the first one).

The idea is to keep is short, simple, yet at least touch on the major objections that have been raised about the definition of risk.

Ferri does a nice job of covering all of this in Chapter 2 (Understanding Investment Risk) of the referenced book, but of course we want something much shorter.

Thoughts?

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 2:25 pm

bob90245 wrote:1) Remove the extra vertical bar that is labeled "Risk"

2) Underneath the skinny part of the lower dashed line on the left, write "Less Risk"

3) Underneath the wide part of the lower dashed line on the right, write "More Risk"

4) Then you can make a connecting solid double-arrow pointing to "Less Risk and "More Risk" in parallel and below the lower dashed line. This implies the possibility of a continuous range of risk and can be further explained in Part 2.


Whatever we do, I like that the increasing distance between the dashed lines demonstrates increasing dispersion. In the context of the article, we want to emphasize dispersion of returns as risk. Not sure about doing something that emphasizes the lower dashed line and ignores the upper one. Not saying the idea is not good; maybe some combination.

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Re: Wiki - Investment Risk (revised for new investors)

Post by GregLee » Sun Apr 08, 2012 2:41 pm

Kevin M wrote:In rewording, I'd still like to keep the focus on uncertainty as risk, not just as "you might lose money", ...

I support the idea of using "risk" unambiguously in just this one sense of "uncertainty", and specifically meaning standard deviation. It's an artificial use of the word, and I wish the language of finance had grown up in some other way, but what can you do? That's how it's used. But still worse than an artificial jargony use, which I think most people can cope with, once it's been pointed out, is to use the term ambiguously or vaguely, drifting about between "dispersion of results" and "probability of loss", letting the context decide what is meant, if the writer even knows what is meant. Now that sort of indeterminacy of terminology is hard for everyone to cope with, novice or expert.
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Re: Wiki - Investment Risk (revised for new investors)

Post by GregLee » Sun Apr 08, 2012 2:51 pm

LadyGeek wrote:I used the same data file and created a new chart.

Image

Shouldn't the figure be tilted upwards to the right to reflect the generally accepted idea that expected return increases with increasing risk?
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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Sun Apr 08, 2012 2:54 pm

GregLee wrote:
LadyGeek wrote:I used the same data file and created a new chart.

Image

Shouldn't the figure be tilted upwards to the right to reflect the generally accepted idea that expected return increases with increasing risk?


No. The point you correctly want to see would be illustrated by drawing a line through the hash marks and noting that said line slants up to the right.

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Re: Wiki - Investment Risk (revised for new investors)

Post by yobria » Sun Apr 08, 2012 2:59 pm

GregLee wrote:
LadyGeek wrote:I used the same data file and created a new chart.

Image

Shouldn't the figure be tilted upwards to the right to reflect the generally accepted idea that expected return increases with increasing risk?


Yes, I think that chart is accurate for someone whose holding period is a year - but then, they shouldn't be owning stocks in the first place, as the chart implies. A 20-30 year chart, showing the long term benefits of stocks (returns compound with time, standard deviation with only the square root of time), should also be included.

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Re: Wiki - Investment Risk (revised for new investors)

Post by bob90245 » Sun Apr 08, 2012 3:11 pm

yobria wrote:Yes, I think that chart is accurate for someone whose holding period is a year - but then, they shouldn't be owning stocks in the first place, as the chart implies. A 20-30 year chart, showing the long term benefits of stocks (returns compound with time, standard deviation with only the square root of time), should also be included.

Remember, this chart came about to be simpler for novices to understand. The other charts are more advanced in nature and will likely be shown in part 2. At least, that is how I understand from what Kevin has written upthread.
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Re: Wiki - Investment Risk (revised for new investors)

Post by GregLee » Sun Apr 08, 2012 3:14 pm

Kevin M wrote:This (current) definition applies to portfolio theory. Note that it does not distinguish between loss and gain, does not mention time frame, and does not consider the investment goal.

I think that last about "investment goal" is pretty important, for two reasons. (1) It's a common fallacy ("loss aversion") to be concerned about the danger of your portfolio falling below its current worth instead of worrying about the future danger of your portfolio falling short of your retirement goal. (2) People worried about risk tend to underestimate the importance of high expected returns in reducing the chance that a portfolio will fall short of a retirement goal.
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 3:18 pm

dbr wrote:No. The point you correctly want to see would be illustrated by drawing a line through the hash marks and noting that said line slants up to the right.

This! This was illustrated in the original sketch, and I think is an important part of the overall message the chart (and the entire article) is intended to convey.

Kevin
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 3:20 pm

bob90245 wrote:Remember, this chart came about to be simpler for novices to understand. The other charts are more advanced in nature and will likely be shown in part 2. At least, that is how I understand from what Kevin has written upthread.

Yes!
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 3:22 pm

GregLee wrote:
Kevin M wrote:This (current) definition applies to portfolio theory. Note that it does not distinguish between loss and gain, does not mention time frame, and does not consider the investment goal.

I think that last about "investment goal" is pretty important, for two reasons. (1) It's a common fallacy ("loss aversion") to be concerned about the danger of your portfolio falling below its current worth instead of worrying about the future danger of your portfolio falling short of your retirement goal. (2) People worried about risk tend to underestimate the importance of high expected returns in reducing the chance that a portfolio will fall short of a retirement goal.

I agree!
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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Sun Apr 08, 2012 3:25 pm

Kevin M wrote:Thoughts on revised intro to address many of the concerns that have been raised. This is a paraphrased version of the next "improvement" I have in mind.

  • This (current) definition applies to portfolio theory. Note that it does not distinguish between loss and gain, does not mention time frame, and does not consider the investment goal.

    I think if the definition applies to portfolio theory and only to portfolio theory, then it is a waste of time to discuss it. But, of course, the definition (that risk is SD) does not apply only to portfolio theory. The idea has powerful explanatory value of all kinds of things. The definition does distinguish between loss and gain because SD applies to both loss and gain rather than to neither. The question of whether the outcomes are symmetric with respect to upside and downside is a second order concern. The definition does mention time frame in that we use annual returns, or if we don't we specify something else. An obvious step is that one needs to discuss how annual returns compound over time and how dispersion in the results compounds over time. Norstad's little discussion is an example. There are tricky technical details about that, but those are all second order, even the discussion about RTM. The discussion does include the investment goal because we can compare the dispersion of results to the point goal. That is already even on the chart where we see the bar and the hashmark and the amount of the bar that falls below the zero line, if loss is the concern. The strength of this whole discussion is how much the basic concept of statistical distribution does tell you rather than all the nit-picking about what it does not tell you.

    Disclaimer: If you have been applying these tools all your life maybe you see the obvious when it is not evident to someone not previously exposed to the concepts. Kudos to you for asking for feedback from a range of people -- absolutely the right thing to do
    .
  • Typical individual investors think of risk as the possibility that their investments could lose money. Cite Rick Ferri, "All About Asset Allocation" (2006), p.23 (Rick has enough experience with individual investors to be a credible source). They are likely to be quite happy with an investment return that is greater than expected.
  • In financial planning, the investment goal must be considered when defining risk. If the goal of the investment is to fund retirement, then risk is the possibility that the investor will outlive the investment portfolio. (Liability matching, without using the term; or use the term if we think it won't be confusing)

    Exactly. And there are models for that. Why would anyone think you get the answer to that problem without asking the right question to start with. However, those models are just calculations that compute a different statistic from the underlying data than the SD. People do a lot of different things with data than calculate the mean and the SD when mean and SD aren't the answer to the question. You already listed retirement ruin and shortfall as risks in investing. The problem is that SD isn't the definition of risk. SD is a fact about the data that implies that various risks may exist. What is with this obsession to have a definition of risk when risk is a complicated and mult-faceted concept?


  • Maybe define "expected return" using the wording I quoted upthread " expected return is the best estimate available of future returns". It seems understandable (to me), yet accurate without referencing statistical terms or any math.

    Expected return is not the best estimate available of future returns. Expected return is the best estimate available of the average of a range of possible future returns. The concept cannot be made any more simple than it is. Anyway you already reported that your mini focus panel didn't have an issue with the idea and the picture is pretty clear about it. Anyway "best estimate" is either a concept that you put some mathematical definition around or it is even more meaningless than the original term
  • This article focuses on the definition of risk as used in portfolio theory (the first one).

The idea is to keep is short, simple, yet at least touch on the major objections that have been raised about the definition of risk.

Ferri does a nice job of covering all of this in Chapter 2 (Understanding Investment Risk) of the referenced book, but of course we want something much shorter.

Talking about the definition of risk as used in portfolio theory is helpful because it will prevent confusion as soon as someone actually starts to look at portfolio theory. Having the background that anyone faced with trying to study a probabilistic phenomenon such as investment returns will naturally fall back on the tools of statistical analysis helps, but not everyone has that background. The portfolio theorists are guilty of a heavy sin in calling variability, or whatever you want, "risk," but how were they to know someone would actually read their stuff. Besides, as mentioned above, there are actually plenty of good reasons why this risk is risk or at least related to risk.

Finally, there are just some things where you have to read the book, or several books, and when you take the cheap way out you get what you paid for.


Thoughts?

PS We have been talking enough now that I am just laying out thoughts as directly as they come to mind and this is not argumentative. You are very generous to undertake the effort here.

Kevin

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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Sun Apr 08, 2012 3:32 pm

GregLee wrote:
Kevin M wrote:This (current) definition applies to portfolio theory. Note that it does not distinguish between loss and gain, does not mention time frame, and does not consider the investment goal.

I think that last about "investment goal" is pretty important, for two reasons. (1) It's a common fallacy ("loss aversion") to be concerned about the danger of your portfolio falling below its current worth instead of worrying about the future danger of your portfolio falling short of your retirement goal. (2) People worried about risk tend to underestimate the importance of high expected returns in reducing the chance that a portfolio will fall short of a retirement goal.


This is very true. It is an example of the fact that characterizing the probability distribution of returns does not answer the question of what will happen to my portfolio and my income stream in retirement. It illustrates that looking at the probability distribution tells you that all kinds of risks can exist, but that to quantify any particular one requires asking the right question then computing something that addresses the question asked. That is also why people need to stop worrying about the definition of risk and start asking how to answer the various questions that may be of concern. The original entry in the Wiki actually does just find in listing all kinds of different risks and does not get hung up on a need for one single definition. In that respect it is just like what one finds in any well written book on investing that starts from beginning concepts. I think its fine and doesn't need a lot of fixing.

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 3:41 pm

GregLee wrote:
Kevin M wrote:In rewording, I'd still like to keep the focus on uncertainty as risk, not just as "you might lose money", ...

I support the idea of using "risk" unambiguously in just this one sense of "uncertainty", and specifically meaning standard deviation. It's an artificial use of the word, and I wish the language of finance had grown up in some other way, but what can you do? That's how it's used. But still worse than an artificial jargony use, which I think most people can cope with, once it's been pointed out, is to use the term ambiguously or vaguely, drifting about between "dispersion of results" and "probability of loss", letting the context decide what is meant, if the writer even knows what is meant. Now that sort of indeterminacy of terminology is hard for everyone to cope with, novice or expert.

I think we are in agreement here. I would state it this way in the context of the article:

  • Risk is the uncertainty of returns (there are others definitions, but this is the one we are basing the article on)
  • Uncertainty of returns can be illustrated by looking at dispersion of returns for different assets.
  • A numerical value can be used to quantify dispersion of returns; it is standard deviation (or variance)
  • We know that investors are mostly concerned about loss, but given that investment returns historically have been roughly normally distributed (yes, I know this is debated, but it is stated in our references), using variance instead of semi-variance is valid. (I'm not suggesting we state this in the this article, but this is part of the context of the article).
  • Therefore, we should be consistent in discussing risk as uncertainty of returns, as illustrated by dispersion of returns and as measured by standard deviation.

Others probably would like the focus to be more on risk as the possibility of loss. That was not the idea behind this article (well, not mine anyway), but that doesn't mean we can't just write an entirely different article, or totally morph this one into something else. I'm more interested in further development of a Bogleheads wiki reference that discusses risk within the context of portfolio theory.

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Re: Wiki - Investment Risk (revised for new investors)

Post by LadyGeek » Sun Apr 08, 2012 3:42 pm

Next update. The top chart is bob90245's suggestions. The bottom chart is dbr's shortfall / windfall, including a "beware, there be dragons" area marked out.

I don't think you need to draw a line across the averages - it's too much for the chart and easily explained in the text. The average trend is also easier to see in the bottom chart.

Image

(Scaled to 499 pixels. Full size: File:Range of Annual Returns1.jpg - Bogleheads. All images are uploaded in the wiki.)
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Re: Wiki - Investment Risk (revised for new investors)

Post by bob90245 » Sun Apr 08, 2012 4:04 pm

LadyGeek wrote:Next update. The top chart is bob90245's suggestions.
Image

Top chart is even better! :sharebeer
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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Sun Apr 08, 2012 4:37 pm

Kevin M wrote:
  • Risk is the uncertainty of returns (there are others definitions, but this is the one we are basing the article on)
  • Uncertainty of returns can be illustrated by looking at dispersion of returns for different assets.
  • A numerical value can be used to quantify dispersion of returns; it is standard deviation (or variance)
  • We know that investors are mostly concerned about loss, but given that investment returns historically have been roughly normally distributed (yes, I know this is debated, but it is stated in our references), using variance instead of semi-variance is valid. (I'm not suggesting we state this in the this article, but this is part of the context of the article).
  • Therefore, we should be consistent in discussing risk as uncertainty of returns, as illustrated by dispersion of returns and as measured by standard deviation.

Others probably would like the focus to be more on risk as the possibility of loss. That was not the idea behind this article (well, not mine anyway), but that doesn't mean we can't just write an entirely different article, or totally morph this one into something else. I'm more interested in further development of a Bogleheads wiki reference that discusses risk within the context of portfolio theory.

Kevin


I think this is sound and a good way to keep the discussion within practical bounds.

The problem of retirement ruin is already discussed in the Wiki under SWR.

Isn't the possibility of loss already illustrated in the article as it stands? How hard can it be to see that when the probable range is larger than the expected return, that this means some possible returns are negative? The relative magnitude is also made evident in the figure. Also made evident is the fact that if one strives for greater returns it is more and more possible to experience greater and greater losses. What more does one need to do when simply showing the basic idea? If someone is worried that experiencing a loss will cause retirement ruin, then cycle back to the above, except people may not know that at first.

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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Sun Apr 08, 2012 4:41 pm

LadyGeek wrote:Next update. The top chart is bob90245's suggestions. The bottom chart is dbr's shortfall / windfall, including a "beware, there be dragons" area marked out.


I like the top chart better too.

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sun Apr 08, 2012 4:41 pm

I like both, but the top one (original idea) is more in line with the thrust of the article, IMO, and cleaner and simpler. It's easier for me to tell at a glance what it is illustrating.

I do miss the average trend line. Could we make it a very light, dotted line? It could even be non-continuous so it does not interfere with the "average" indicators.

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Re: Wiki - Investment Risk (revised for new investors)

Post by LadyGeek » Sun Apr 08, 2012 5:00 pm

I added the average trend line. Since I uploaded a new version to the same file, the previous image is now overwritten. IOW, the prior posts with this image will now show the trend line.

Image

Scaled for 466 pixel resolution. The full image (and previous versions) are in the wiki: File:Range of Annual Returns1.jpg - Bogleheads

BTW, the Excel file is available for download in Google Docs: Risk - Historical Performance of Bonds and Stocks.xlsx - Google Docs. You can view it online, but the charts are illegible. File --> Download. If the charts change again, I'll keep it up to date. (The link is also in the wiki, External links.)

Update: Average trend line removed as explained in the following posts.)
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Re: Wiki - Investment Risk (revised for new investors)

Post by bob90245 » Sun Apr 08, 2012 5:01 pm

Kevin M wrote:I do miss the average trend line. Could we make it a very light, dotted line? It could even be non-continuous so it does not interfere with the "average" indicators.

I would cast a "NO" vote. I don't see it necessary to add any more lines. It'll just clutter things up.
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Re: Wiki - Investment Risk (revised for new investors)

Post by GregLee » Sun Apr 08, 2012 5:40 pm

LadyGeek wrote:I added the average trend line.

But if the trend line represents the future expected return, the upward and downward risk lines should go up and down with respect to this trend line, not (as in the present diagram) with respect to the 0 return line.
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Re: Wiki - Investment Risk (revised for new investors)

Post by LadyGeek » Sun Apr 08, 2012 6:47 pm

Good point, I see your concern and concur. My additional thought is that a trend line implies that you will get a better return with stocks - which can be misleading in the wrong circumstance. That's 3 votes to modify (or remove) the trend line, so I reverted the change in the wiki. Any explanations can be dealt with in the text. All the forum post links will now show the average trend line missing.(Refer to my previous post for the chart.)

The full image (and previous versions) are in the wiki: File:Range of Annual Returns1.jpg, the Google Docs file is up to date.
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Re: Wiki - Investment Risk (revised for new investors)

Post by peppers » Sun Apr 08, 2012 8:42 pm

Kevin M wrote:
peppers wrote:I thought it was straightforward and not that difficult to understand. My intent is to bring this up with my (4) adult children at dinner on Sunday. (Insert image of deer in the headlight look and thoughts of ...Dad's talking Boglehead again)

Thanks peppers! I know exactly what you mean about talking with the adult kids ("there Dad goes again"). If they don't fall asleep on you, let us know how it goes.

Kevin


I had the troops and 2 daughters in law read the investment philosphy and risk article. They all agree that the Boglehead philosophy is just good common sense. On to risk. They grasped the charts in figure 1. Got a handle on standard deviation. The only rough patch? TIPS. Who would have known. What was more engaging, as we sat around after dinner, portfolio allocation came up, indexing, ER's, ROTH's, and 401k's. It was the forum....LIVE. Again, thanks to all for the good work and effort putting the information out there.
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Mon Apr 09, 2012 12:45 am

Thanks again peppers. Always nice to hear about real personal interactions stimulated by Bogleheads.

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Mon Apr 09, 2012 12:48 am

Minor inputs. I got two inputs about the mention of 30-day t-bills. One was "why didn't we have a link for it". I think answer is that we don't have a wiki entry for it. Other comment was "I have no idea what a 30-day treasury bill is".

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Mon Apr 09, 2012 12:51 am

Some other unabridged feedback:

- Love the section "Uncertainty of returns as risk". As a reader, it is clear which methods hold the most risk and the charts are helpful as well.

- In "Relationship between Risk and Return", I was confused and stuck in the 1st paragraph by the "realized return" but it is explained (historical) in the 2nd paragraph. I believe you must have written this summary: "This demonstrates one of the most fundamental axioms of investing: Risk and return are inextricably related. Higher returns generally can be achieved only by taking more risk, but because the risk exists, the higher expected returns may not result in higher realized returns." Perfect.

- "Diversification": I just learned about this from you! Easy to understand (only because you went over it with me).

- The glossary at the end is helpful too.


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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Mon Apr 09, 2012 1:21 am

LadyGeek wrote:Good point, I see your concern and concur. My additional thought is that a trend line implies that you will get a better return with stocks - which can be misleading in the wrong circumstance.

Although I think somehow we're missing out on illustrating the concept of increasing expected returns associated with increasing risk by leaving the average line out, I agree it adds clutter to the chart. I am torn.

I disagree that it implies that you will get a better return with stocks any more than the risk lines imply that stocks are more risky. Either expected returns and risk are related or they aren't. But we do have to be careful to emphasize that the future may not resemble the past.

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Re: Wiki - Investment Risk (revised for new investors)

Post by HongKonger » Mon Apr 09, 2012 3:29 am

I'm a novice and I like the top chart more. I especially like that LadyGeek put US in front of things ...I have no concept what a T Bill is, but with the addition of US, I know its something unique that you have over there. But does there need to be US in front of bonds and stocks or does the associated risk not apply to other countries' stocks and bonds?

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Mon Apr 09, 2012 12:12 pm

HongKonger wrote:I'm a novice and I like the top chart more. I especially like that LadyGeek put US in front of things ...I have no concept what a T Bill is, but with the addition of US, I know its something unique that you have over there. But does there need to be US in front of bonds and stocks or does the associated risk not apply to other countries' stocks and bonds?

Thanks for the input HongKonger.

Yes, the same concepts apply to cash, bonds and stocks in any country (think of T-Bills as cash). We just happened to use data for US securities, thus use "US in the labels to clarify. The specific ranges of returns (vertical sizes of lines) and average values will be different for each country. The historical data for some countries may not demonstrate the principle as well, since the expected returns may not have been realized, but in general the historical returns for global cash, bonds and stocks has followed the same pattern.

It might be good for us to include a few words clarifying this. We could cite something like "Triumph of the Optimists" as our source.

Thanks,

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Re: Wiki - Investment Risk (revised for new investors)

Post by LadyGeek » Mon Apr 09, 2012 3:36 pm

peppers wrote:I had the troops and 2 daughters in law read the investment philosphy and risk article. They all agree that the Boglehead philosophy is just good common sense. On to risk. They grasped the charts in figure 1. Got a handle on standard deviation. The only rough patch? TIPS. Who would have known. What was more engaging, as we sat around after dinner, portfolio allocation came up, indexing, ER's, ROTH's, and 401k's. It was the forum....LIVE. Again, thanks to all for the good work and effort putting the information out there.

Actually, that was my thought when I first saw the term - a Treasury somethingoranother. :shock: Can we change the text (without bypassing the terminology)? I suggest:

From:
Uncertainty in real returns can be eliminated by investing in inflation-indexed securities, such as Treasury Inflation Protected Securities (TIPS) and Series I Savings Bonds (I Bonds).

To:
Uncertainty in real returns can be eliminated by investing in U.S. government-issued bonds that help protect against inflation, such as Treasury Inflation Protected Securities (TIPS) and Series I Savings Bonds (I Bonds).

HongKonger wrote:I'm a novice and I like the top chart more. I especially like that LadyGeek put US in front of things...

Thanks. I'm used to working in a multinational environment and try to give perspective where possible.

======================
There are many comments on the upper chart, but I haven't seen any on the lower chart? In any case, I split them into 2 distinct files - you don't have to keep them together (or even within the same article). The forum software is showing them full size - we'll scale to fit in the wiki.

Image

Image
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Re: Wiki - Investment Risk (revised for new investors)

Post by GregLee » Mon Apr 09, 2012 5:15 pm

I think "U. S. Treasury Bills" is rather esoteric, as compared with cash or a checking account. I have some acquaintance with cash, bonds, stocks, but I've never in my life held a T Bill, and my bonds and stocks are not confined to U. S. ones (why should they be?).
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Mon Apr 09, 2012 5:38 pm

GregLee wrote:I think "U. S. Treasury Bills" is rather esoteric, as compared with cash or a checking account. I have some acquaintance with cash, bonds, stocks, but I've never in my life held a T Bill, and my bonds and stocks are not confined to U. S. ones (why should they be?).

How about "Cash (T-Bills)" or something like that as the label?

Our data set just happens to be for US securities. For bonds, most Bogleheads are in US bond funds. For stocks, we could use a global portfolio, maybe 70/30 US/International (as in the VG Target Retirement and LifeStrategy funds), but someone would have to grab the data from somewhere. Regardless, the graph makes the main points.

Perhaps we could add a few simple words to clarify that the chart does not imply that one should invest only in US securities, nor does it imply that the averages represent expected returns going forward.

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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Mon Apr 09, 2012 5:50 pm

LadyGeek wrote:Can we change the text (without bypassing the terminology)? I suggest:

From:
Uncertainty in real returns can be eliminated by investing in inflation-indexed securities, such as Treasury Inflation Protected Securities (TIPS) and Series I Savings Bonds (I Bonds).

To:
Uncertainty in real returns can be eliminated by investing in U.S. government-issued bonds that help protect against inflation, such as Treasury Inflation Protected Securities (TIPS) and Series I Savings Bonds (I Bonds).


My preference would be to leave the existing sentence as is, and maybe add one sentence clarifying that these types of securities are bonds for which the returns are higher if the inflation rate is higher, and vice versa. No matter what we do, we are not going to explain TIPS or I Bonds here. There are links to wiki articles on them if people want to learn more about them. I don't think the input was that the sentence was unclear, just that TIPS were the topic that generated more questions.

There are many comments on the upper chart, but I haven't seen any on the lower chart? In any case, I split them into 2 distinct files - you don't have to keep them together (or even within the same article). The forum software is showing them full size - we'll scale to fit in the wiki.

We have seen several comments that indicate people prefer the top chart to bottom chart, which to me is a comment on the lower chart. Perhaps there are more comments on the upper chart because that's the one that people like more, so they're helping to make it better. I've been assuming we'd just use the upper chart in the risk article.

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Re: Wiki - Investment Risk (revised for new investors)

Post by HongKonger » Mon Apr 09, 2012 6:10 pm

The second graph is much harder to understand: the red line looks like it has something to do with time and the terms shortfall and windfall are not obvious, or why they are applied to Bonds. It seems there is too much going on that needs to be made sense of in the second graph and whereas the first graph can easily be grasped straight off, the second feels overly complicated.

My two pennies worth.

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Re: Wiki - Investment Risk (revised for new investors)

Post by LadyGeek » Mon Apr 09, 2012 6:47 pm

Agreed to use the upper chart, that's why I split them. You can also use the "upper" chart to as a lead into the return dispersion chart (standard deviation perspective). It's the same data source, so you have continuity of discussion.

The bottom chart was a suggestion by dbr to show the implications of using averages in terms of planning; hence the shortfall / windfall concept. It's probably better used elsewhere. (But I like it.)

Kevin M wrote:How about "Cash (T-Bills)" or something like that as the label?

Our data set just happens to be for US securities. For bonds, most Bogleheads are in US bond funds. For stocks, we could use a global portfolio, maybe 70/30 US/International (as in the VG Target Retirement and LifeStrategy funds), but someone would have to grab the data from somewhere. Regardless, the graph makes the main points.

I would leave the charts alone. For teaching purposes, I think sticking to "standard" securities (or indexes) is best. I don't think the concepts will change, just the absolute results. Straying into proprietary funds may introduce a bias where one may question what happens with Fidelity, etc.

I would also leave the label "as-is." If we want to teach terminology, why change here?

On another point:
wiki wrote:The term cash often is used to refer to money market securities and money in bank accounts. Vanguard refers to these types of assets as short-term reserves.

"Short term reserves" are not exclusive to Vanguard, which is implied in the current text. Short term reserves are bank deposits, U.S. Treasury bills (spell out "T-bill"), and short term bonds which mature in less than a year (I can't find a credible source to confirm). Compare to long-term reserves, which is everything else.
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Mon Apr 09, 2012 8:28 pm

LadyGeek wrote:
wiki wrote:The term cash often is used to refer to money market securities and money in bank accounts. Vanguard refers to these types of assets as short-term reserves.

"Short term reserves" are not exclusive to Vanguard, which is implied in the current text. Short term reserves are bank deposits, U.S. Treasury bills (spell out "T-bill"), and short term bonds which mature in less than a year (I can't find a credible source to confirm). Compare to long-term reserves, which is everything else.

The only reason for the Vanguard short-term reserves statement is that Vanguard shows it as one of the three major asset classes in it's asset mix charts, like when you first log on to your account, in using the portfolio watch tool, and in the asset breakdowns for its funds (e.g., see Target Retirement Income fund). Other places they refer to this asset class as "cash", like in "The truth about risk" page. Since many Bogleheads use Vanguard, it seems useful to clarify that when they see "short-term reserves" on the Vanguard website, it's the same asset class as "money market securities" or "cash".

I believe "cash" (and cash equivalents) is the most widely used term to describe this asset class (but it's not the term used in the textbooks; it's not even indexed in the three investing textbooks I own). For example:

Investopedia wrote:The three main asset classes - equities, fixed-income, and cash and equivalents - have different levels of risk and return, so each will behave differently over time.

Read more: http://www.investopedia.com/terms/a/ass ... z1rb1OdGL8


Also FYI:

Wikipedia wrote:In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately (as in the case of money market accounts).


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Re: Wiki - Investment Risk (revised for new investors)

Post by YDNAL » Tue Apr 10, 2012 6:56 am

dbr wrote:
YDNAL wrote:A novice investor sees (everywhere) the definition of risk as involving exposure to danger, harm, loss. Defining risk as "uncertainty of expected return," as demonstrated in "historical distribution of returns" is not basic and likely confusing (or even wrong to them :wink: ).
Wiki wrote:“Risk is the uncertainty that an investment will earn its expected rate of return.”[1]

I don't agree. The first and most fundamental thing to be learned about investing is this characteristic of uncertainty in returns.....

You don't agree that:
1. Novice investors (actually everyone) finds the definition of risk as involving exposure to danger, harm, loss.

or

2. Defining uncertainty of expected return is not basic and likely confusing (even wrong).

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