Wiki - Investment Risk (revised for new investors)

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Kevin M
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Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Thu Apr 05, 2012 4:22 pm

One of the most fundamental principles a new investor should understand is the relationship between investment risk and investment returns. A team of Boglehead Wiki contributors has collaborated to completely rewrite the Wiki "Risk" article. This article:

  • Uses historical data to demonstrate why stocks are riskier than bonds, and bonds are riskier than cash
  • Explains the relationship between risk and return, a fundamental axiom of investing
  • Explains the principles of managing risk through diversification and asset allocation
  • Provides a brief overview of various types of investment risk

Wiki article link: Risk and return: an introduction

This is the second article included in the Introduction to Investing section of the Bogleheads® investing start-up kit.
The first article in the kit is Bogleheads® investment philosophy, and we recommend that investors new to Bogleheads start there. Our revised "Risk" article is intended for investors who want to expand their understanding of investment risk and its relationship to investment returns.

Comments / questions / concerns are welcome. Investors new to Bogleheads are encouraged to post comments; this article is written for you. Is it too difficult to understand? Did we miss anything?

Thanks!

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

Post by magician » Thu Apr 05, 2012 4:39 pm

Why is cash considered to be a different asset class than bonds? Isn't cash just another name for a short-term bond (e.g., a T-bill)?

(This is a topic debated ad infinitum here at Bogleheads; my question is really one of why the particular viewpoint in the article was chosen.)
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Re: Wiki - Investment Risk (revised for new investors)

Post by SSSS » Thu Apr 05, 2012 4:52 pm

magician wrote:Why is cash considered to be a different asset class than bonds? Isn't cash just another name for a short-term bond (e.g., a T-bill)?

(This is a topic debated ad infinitum here at Bogleheads; my question is really one of why the particular viewpoint in the article was chosen.)


I think it makes sense to say "cash" when there's no interest rate risk (this would include savings bonds) and "bonds" when there is interest rate risk.

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

Post by Kevin M » Thu Apr 05, 2012 4:58 pm

magician wrote:Why is cash considered to be a different asset class than bonds? Isn't cash just another name for a short-term bond (e.g., a T-bill)?

(This is a topic debated ad infinitum here at Bogleheads; my question is really one of why the particular viewpoint in the article was chosen.)

Good question.

The primary references we used are investment textbooks, which are based on the academic literature. The intention was to avoid personal viewpoints, and simply present it the way it's presented in the references.

Money market securities (typically 30-day T-Bill) are presented in the literature as the risk-free asset, and bonds are considered part of the "risky portfolio". Portfolio theory combines different portions of the risk free asset with the risky portfolio to manage risk. Different ratios of bonds and stocks are used to create different risky portfolios.

We are building from the ground up. There is an advanced article in the works that will go into more detail.

Note that Vanguard treats "short-term reserves" as a separate asset class, so this should be natural for investors who use Vanguard (even though some of us may disagree with it).

I personally treat fixed income and stocks as the two main asset classes, then divide fixed income into different maturities, cash being the shortest maturity. I don't see the point in establishing a line at an arbitrary maturity to distinguish between cash and bonds, although industry practice seems to be to treat one-year maturity as the dividing line (e.g., money market funds). My personal viewpoint did not enter into the article. There should be no viewpoint to challenge if we have done our job of representing the references accurately.

Thanks,

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

Post by yobria » Thu Apr 05, 2012 5:03 pm

Looks solid, good work. One risk you might consider adding is "counterparty" or "intermediary" risk - the risk you take when entrusting your savings to one or more financial institutions. Risks include: fraud (Madoff, MF Global), high fee or otherwise inferior investment choices (typical "full service brokerage" portfolios), hidden fees or fee increases, insolvencies (banks over the past few years) etc. Solutions are to educate yourself, use as few intermediaries as possible (invest directly with the fund company), be aware of the types of insurance and insurance limits protecting the investment, read the fine print in your investment contracts, and always deal with well known financial institutions.

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

Post by bobcat2 » Thu Apr 05, 2012 6:09 pm

Hi Kevin M. You wrote.
Money market securities (typically 30-day T-Bill) are presented in the literature as the risk-free asset, and bonds are considered part of the "risky portfolio".
This is a canard that is oft-repeated, but is true in only a very small minority of real world investment cases.

Compare the above definition of risk-free asset with what I wrote on this board in January about risk-free assets.
What is the risk-free asset?

There really is no risk-free asset or assets, but there are lowest risk or safest assets in different situations. Since safest asset is a term rarely used, I will use the term risk-free when I mean safest or lowest risk asset.

In the theory of portfolio selection a risk-free asset is defined as a security that offers a perfectly predictable rate of return in terms of the selected unit of account and the length of the investor's decision horizon.

So if the unit of account is the US dollar and the decision horizon is three months, the risk-free asset is a Treasury bill that matures in three months. If the decision horizon is 20 years then the risk-free asset is a 20 year zero coupon Treasury bond, assuming the unit of account is nominal dollars. If the decision horizon is 15 years and the unit of account is real consumption, then the risk-free asset is a 15 year TIPS bond. If the decision horizon is every year until I die, and I am 62 or older and the unit of account is real consumption, then the risk-free asset is Social Security or a private real life annuity. If the unit of account is college tuition and the decision horizon is 4 years of college beginning 6 years from now, then the risk-free asset is a pre-paid college tuition plan. If the unit of account is the Swiss franc and the decision horizon is two months, then the risk-free asset is a franc bill that matures in two months.

There is plenty of risk in cash (or ST Treasury bills) if the decision horizon is long. If the unit of account is real consumption and the decision horizon is long, cash becomes a very risky asset. Conversely if the decision horizon is short, a long dated TIPS bond is a very risky asset.

In the generic setting, where no specific investor is identified, the risk-free asset refers to an asset that offers a predictable rate of return over the shortest decision horizon. For example, if the US dollar is taken as the unit of account and the shortest decision horizon is one month, then the risk-free rate is the interest rate on a US Treasury bill maturing in one month. But one should be careful not to confuse the risk-free asset in the generic setting with the risk-free asset in particular actual settings.

Now I adopted this definition from the undergraduate textbook, Finance, co-authored by Bodie and Merton. Zvi Bodie is a very well known financial economist and Robert Merton is a Nobel prize winning financial economist who has been described as the Isaac Newton of finance by some. So I believe their views on what constitutes a risk-free asset is the mainstream of the academic literature on the topic.

What you have written is true in the generic setting where we don't know the purpose of the investment or the time horizon of the investment. But in actual specific cases it is not true, unless the investment horizon is short and the unit of account is dollars. In reality the risk-free asset changes with the investment time horizon and the unit of account.

LT bonds are risky assets, if they are part of a portfolio risk management strategy based solely on risk management thru diversification. However, they are very safe assets, much safer then T-bills, if they are being used to match assets to liabilities or goals within the portfolio. In that case the bonds are hedging risk, which reduces risk more than diversification strategies, but unlike diversification, leaves the investor without upside potential for gain above the goal.

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: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Thu Apr 05, 2012 7:05 pm

Hi BobK,

Agree with everything you say. Hopefully if you read the wiki article you will not find anything that conflicts with standard investment theory as taught in undergraduate investment textbooks. Our intention was to follow the wikipedia policy of not engaging in original research, and to rely strictly on credible sources. Note that Bodie is the primary author of one of the primary references used. There should be nothing in this article that is in conflict with that reference.

Note that the article does mention that even money market securities are not truly risk free, and as a matter of fact that no investment is truly risk free:

If inflation is considered, even money market securities have some risk, in that they may not achieve the expected real (inflation-adjusted) return. Unexpected inflation may reduce the real return below the expected return of the money market investment.

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). Of course in return for this reduction in uncertainty, investors must accept lower expected returns. Even inflation-linked securities have risks; e.g., TIPS have interest-rate risk and liquidity risk. No investment is truly risk free.

Keep in mind that this is intended primarily for novice investors, so things like liability matching probably are too advanced for this article. Some contributors focused more on making it readable for beginners, and some more on academic rigor and thoroughness; the result is a compromise, as it was a collaborative effort.

I would not object to adding a sentence or two about liability matching in the section quoted above, but I know the concern is that it may be too complex and confusing for the intended audience. And you're right about context, but that usually isn't covered in a basic introduction to risk and return.

As mentioned, there is a more advanced article in the works, and we can certainly get more into things like liability matching there. As a matter of fact, we started the more advanced article because some collaborators felt this article was getting too complex, and we should keep it focused on novice investors.

The purpose of this thread is to get feedback on the wiki article. I hope we don't scare off newer Bogleheads from giving us feedback on the readability and usefulness of the article.

Hope this makes sense.

Thanks,

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

Post by LadyGeek » Thu Apr 05, 2012 7:16 pm

Hi Kevin M,

Following yobria's comments above, do you think counterparty risk should be in a "beginner" article? If not, perhaps it could be explained in the forthcoming advanced article.

I see counterparty risk mentioned a lot and it's not defined in the wiki. Could counterparty risk be considered a form of credit risk? (I don't know the answer, which is why I'm asking.)

To clarify Kevin M's comments about needing to stay at an introductory level: This article is 2nd in recommended reading for the Bogleheads® investing start-up kit. The first article is the Bogleheads® investment philosophy, so you can see how this fits in the overall tutorial framework.
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Thu Apr 05, 2012 7:52 pm

Counterparty risk is not in the index of any of my three investing textbooks. Here's the definition from wikipedia:

Counterparty risk, known as default risk, is the risk that an organization does not pay out on a bond, credit derivative, trade credit insurance or payment protection insurance contract, or other trade or transaction when it is supposed to.[14] Even organizations who think that they have hedged their bets by buying credit insurance of some sort still face the risk that the insurer will be unable to pay, either due to temporary liquidity issues or longer term systemic issues.[15]
Large insurers are counterparties to many transactions, and thus this is the kind of risk that prompts financial regulators to act, e.g., the bailout of insurer AIG.
On the methodological side, counterparty risk can be affected by wrong way risk, namely the risk that different risk factors be correlated in the most harmful direction. Including correlation between the portfolio risk factors and the counterparty default into the methodology is not trivial, see for example Brigo and Pallavicini.[16]
A good introduction can be found in a paper by Michael Pykhtin and Steven Zhu.[17]


I think we hear a lot about it because it was a big deal in the recent financial crisis; i.e., the risk showed up. So now people are more aware of it. Does not seem like a topic for novice investors.

Yobria's examples bring it down more to the level of the retail investor. You know that I prefer relying on credible sources; you can already see the debates popping up, and the use of credible sources it intended to minimize and hopefully resolve these. If there is a credible source that has a short, understandable definition that gets Yobria's points across, then we certainly can include it in the list of definitions. Others may not even require a credible source, but then it's more open to debate as to the accuracy of the definition.

Note that wikipedia is not considered a credible source:

Wikipedia wrote:Wikipedia is not considered a credible source. Wikipedia is increasingly used by people in the academic community, from freshman students to professors, as an easily accessible tertiary source for information about anything and everything. However, citation of Wikipedia in research papers may be considered unacceptable, because Wikipedia is not considered a credible or authoritative source.[1][2]

This is especially true considering anyone can edit the information given at any time.


Ironic: citing wikipedia to show that wikipedia is not a credible source. :oops:

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

Post by bobcat2 » Thu Apr 05, 2012 8:03 pm

It is expected that before one takes a course in investments one should take a beginning course in finance. Your definition of risk-free conflicts with what is meant by risk-free in introductory undergrad textbooks on finance. That is a problem. The bigger problem is that in many cases T-bills are far from a low risk asset. In other words, the definition does not make good sense. If you want to make this simple, take out the jargon on risk-free assets. That is a better approach than putting it in wrong. A 30 day T-bill is a low risk asset for someone with a 30 day investment horizon. Is the beginning investor portion of the Wiki geared towards investors with 30 day investment horizons?

T-bills can be very risky. For example, according to Triumph of the Optimists in the decade of the 1940s T-bills had an annual real rate of return of -4.7%. So rolling over T-bills in the 1940s turned out to be an extremely risky endeavor. By comparison the annual real return on stocks in the 40s was 4.0% and the annual real return on Treasury bonds was -2.0%. Good luck and Godspeed to the person in 1950 trying to tell someone who held bills from 1940-49 that the bills were a risk-free asset.

If at the beginning you only want to talk about risk transfer thru diversification, then tell the reader that later you will cover the other two risk transfer methods of hedging and insuring.

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

Post by Kevin M » Thu Apr 05, 2012 8:55 pm

bobcat2 wrote:Your definition of risk-free conflicts with what is meant by risk-free in introductory undergrad textbooks on finance.

It is not our definition. It is straight from our references. We are not making this up. It is standard portfolio theory.

BKM wrote:We measure the reward as the difference between the expected HPR on the index stock fund and the risk-free-rate, that is the rate you can earn by leaving money in risk-free assets such as Treasury bills, money market funds, or the bank.


This is from our reference 2 in the article--Bodie is the primary author (who you cited earlier). Bodie wrote a book on Finance. Bodie wrote this book. He didn't seem to have a problem with the conflict you are concerned about.

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

Post by Kevin M » Fri Apr 06, 2012 3:54 am

I hesitate to post this, because I think the point was sufficiently made in my last reply, but I find it too interesting to resist ...
Just happened to scan this paper by John Cochrane (which was being used in another thread to support total market investing rather than tilting):

Portfolio advice for a multifactor world

Near the beginning, Cochrane says:

John H. Cochrane wrote:The new portfolio theory really extends rather
than overturns
the traditional academic portfolio the-
ory. Thus, it’s useful to start by reminding ourselves
what the traditional portfolio theory is and why. The
traditional academic portfolio theory, starting from
Markowitz (1952) and expounded in every finance
textbook, remains one of the most useful and enduring
bits of economics developed in the last 50 years
.

He goes on to say:
The traditional advice is to split your investments
between a money-market fund and a broad-based,
passively managed stock fund.


Much later in the paper, in a section titled "Choosing a risk free rate", he raises the point about the "risk-free rate" being dependent on the investment horizon. He goes on to say:

Thus, the
appropriate bond portfolio to mix with risky stocks in
the logic of figure 1 is no longer so simple as a short-
term money market fund.

Of course, these comments refer to real or in-
dexed bonds
, which are only starting to become easily
available. When only nominal bonds are available,
the closest approximation to a risk-free investment
depends additionally on how much interest rate vari-
ability is due to real rates versus nominal rates. In the
extreme case, if real interest rates are constant and
nominal interest rates vary with inflation, then rolling
over short-term nominal bonds carries less long-term
real risk than holding long-term nominal bonds.


My take-away from this is that it does make sense to present the classical theory in an introductory, very basic article, and then perhaps introduce the time-horizon matching concept in a more advanced article. Just read that last paragraph; definitely not beginner material.

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

Post by richard » Fri Apr 06, 2012 4:31 am

The asset that has the lowest risk depends on your horizon. If you're investing for 30 days, then cash may be appropriate. If you're investing for 30 years, then cash may be less appropriate. You will have to reinvest many times and are at risk that interest rates change, therefore you don't know what you'll have in 30 years. If you bought a 30 year bond, you'd know exactly what you're going to get in 30 years.

It would be useful to distinguish real and nominal returns. Unless you have known future liabilities denominated in nominal terms, real returns are what's important.

"Standard deviation is a statistical measure that often is used to quantify the dispersion (variation) of investment returns." This is true. "which provides a standardized way to compare risk for different investments." This is much more of an issue. Standard deviation is not a very good measure of risk. A large amount of portfolio theory after the original mean variance framework may be viewed as an illustration of the limits (if not outright folly) of standard deviation as a measure of risk.

"Put another way, the risk is that the investment portfolio might not provide its owner—individual or institution—with adequate cash to meet future requirements for essential outlays. In short, that the investor will lose a ton of money, just when it is needed the most." This is a much better statement of risk.

Using historical data and calculating results to two decimal places if not a good idea, IMO. First, we don't have enough data and don't have enough basis to believe the existing data is applicable to the future (different conditions can easily generate different results). I realize this point is not exactly popular. Second, showing results to two decimal places encourages all sorts of bad practices, including an excessive belief in the predictive power of historic data and of math as a reliable guide to investing.

"Uncertainty in real returns can be eliminated by investing in inflation-indexed securities." This is true if you're investing for a specified horizon. However, if you're reinvesting interest payments, you're at risk that real rates will decrease, in which case returns are not completely certain.

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

Post by richard » Fri Apr 06, 2012 4:40 am

Kevin M wrote:My take-away from this is that it does make sense to present the classical theory in an introductory, very basic article, and then perhaps introduce the time-horizon matching concept in a more advanced article. Just read that last paragraph; definitely not beginner material.

I have a different take-away.

Markowitz's mean-variance theory (classical theory) is useful because it points out the relation between risk and return, which is vital. We have advanced since then and at this point variance is taught because it's traditional, not because it's the right thing to do.

Time-horizon matching is not very complicated. I'd bet more people understand time horizon matching than understand standard deviation.

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

Post by Kevin M » Fri Apr 06, 2012 7:26 am

Thanks for the thoughtful feedback Richard.

richard wrote:The asset that has the lowest risk depends on your horizon. If you're investing for 30 days, then cash may be appropriate. If you're investing for 30 years, then cash may be less appropriate. You will have to reinvest many times and are at risk that interest rates change, therefore you don't know what you'll have in 30 years. If you bought a 30 year bond, you'd know exactly what you're going to get in 30 years.

This has already been discussed above. It will be addressed in the more advanced article.

It would be useful to distinguish real and nominal returns. Unless you have known future liabilities denominated in nominal terms, real returns are what's important.

Agreed, but we have to trade this off against simplicity in an introductory article. The presentation in our references do not bring up the nominal vs. real issue at all in the beginning, but introduce it later, which we will do in the more advanced article. We touched on it briefly:

If inflation is considered, even money market securities have some risk, in that they may not achieve the expected real (inflation-adjusted) return. Unexpected inflation may reduce the real return below the expected return of the money market investment.

I tend to want to highlight this more, as do you, but we have to keep it simple given the intended audience. Perhaps we could add a sentence or two to clarify that inflation risk applies to all non-inflation indexed securities.

"Standard deviation is a statistical measure that often is used to quantify the dispersion (variation) of investment returns." This is true. "which provides a standardized way to compare risk for different investments." This is much more of an issue.

I understand your point. The wording was a result of collaboration. I will check references to ensure that we can back it up, and try to ensure it is supported by our references, or change it.

Standard deviation is not a very good measure of risk. A large amount of portfolio theory after the original mean variance framework may be viewed as an illustration of the limits (if not outright folly) of standard deviation as a measure of risk.

This may be true, but nevertheless it still is presented as a widely accepted measure of risk in our references,and is widely used in in practice. I don't know why it would be presented in investment textbooks if it were outright folly. We are not using references from the 1950s. We touch on the shortcomings of using standard deviation as a long-term measure of risk:

For measuring risk over longer time periods, the dispersion of possible cumulative returns is a better measure of risk. This is because over many years, a relatively small difference in annualized rate of return can result in a large difference in cumulative returns.[footnotes 1]

Footnote 1 touches on terminal wealth dispersion. I wanted to include a chart demonstrating this, but it was deemed too complex for this article.

Using historical data and calculating results to two decimal places if not a good idea, IMO. First, we don't have enough data and don't have enough basis to believe the existing data is applicable to the future (different conditions can easily generate different results). I realize this point is not exactly popular. Second, showing results to two decimal places encourages all sorts of bad practices, including an excessive belief in the predictive power of historic data and of math as a reliable guide to investing.

I agree. I support changing to show 0 decimal places. We will discuss it. I also agree that the future may not resemble the past, but historical data still is used to estimate uncertainty of returns. The main point is to illustrate that higher expected returns are associated with higher uncertainty of returns. The specific numbers are not so important.

"Uncertainty in real returns can be eliminated by investing in inflation-indexed securities." This is true if you're investing for a specified horizon. However, if you're reinvesting interest payments, you're at risk that real rates will decrease, in which case returns are not completely certain.

Agreed. I believe we covered this, although perhaps not making your specific point:

Even inflation-linked securities have risks; e.g., TIPS have interest-rate risk and liquidity risk. No investment is truly risk free.


Regardless of the specific risks mentioned, the important point for beginners is that every investment has some type of risk. I guess you can argue that there is no risk if there is a guaranteed nominal or real return that matches your nominal or real liability, but as discussed above, this may be too complex for the intended audience.

Thanks,

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

Post by peppers » Fri Apr 06, 2012 7:33 am

Jumping in. Nice work Kevin and others. Back to risk discussion.
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Fri Apr 06, 2012 7:46 am

peppers wrote:Jumping in. Nice work Kevin and others. Back to risk discussion.

Thank you peppers! It would be nice to hear more from you and others that found it readable, sensible, useful, or whatever. How do you relate to all these somewhat abstract discussions? What could we do to improve it for you?

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

Post by LadyGeek » Fri Apr 06, 2012 8:00 am

I'm one the collaborators and am taking the perspective of the new investor. The concepts of real versus nominal are too complex for a first time introduction to risk and return.

I agree that inflation risk should be clarified to apply to non-inflation adjusted investments. Also, rounding to 0 decimal places is good.

I encourage new investors to jump in and let us know if we're on the right track.

(I'm on my Android now, home internet is down.)
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Re: Wiki - Investment Risk (revised for new investors)

Post by peppers » Fri Apr 06, 2012 8:01 am

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

Post by dbr » Fri Apr 06, 2012 8:09 am

I think it was an excellent article. Before discussing nuances it is essential to put the fundamentals on the table and be sure they are understood. I think this does that very well.

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

Post by bobcat2 » Fri Apr 06, 2012 9:48 am

I believe a much more fruitful way to approach risk in your intro article is to throw out talk about risk-free and standard deviation. You claim to be making this simple and yet your discussion centers on understanding standard deviation and how standard deviation applies to investment returns. For most novice investors theses are two very complicated ideas.

In their place should be a brief discussion of a basic principle that undergirds all of investing, namely the law of one price. Or, in plainer language, there is no free lunch. All important investment decisions involve making trade-offs between what we desire and what we must give up to get it. If you want a higher expected return on your investments, you must take more investment risk and be willing to accept an extremely poor return if the risk shows up, i.e. a resulting return that is much worse than the return from the safer asset with the lower expected return.

I find it difficult to believe that anyone seriously thinks that if an individual is saving and investing for retirement in 20 years the lowest risk (risk-free) asset in their retirement portfolio is 1 month T-bills instead of 20 year TIPS or I-bonds.


Also there is no need to take risk. There is risk capacity (ability to take on risk) and there is risk tolerance (willingness to take risk) but there is no need to take risk. When you are falling short of a financial goal there are 3 things you can do. You can save more (consume less) now, postpone the goal, or take more risk and run the chance of getting an even worse result. Saving more is not a need. Postponing the goal is not a need. And taking more risk is not a need.
The primary references we used are investment textbooks, which are based on the academic literature. The intention was to avoid personal viewpoints, and simply present it the way it's presented in the references.


This stuff about risk as a need is straight from Larry Swedroe who is not an academic. Swedroe is often wrong when he talks about risk and this is one of the many cases where he is wrong about risk. This is simply his opinion and it is not supported by any academic text on finance or investing that I am aware of. And why should it be supported - it doesn't make good sense. So stick to your own rules and take the opinion of one non-academic that conflicts with the academic literature out.

On a more positive note your definition of investment risk is spot-on IMO. :)

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

Post by bob90245 » Fri Apr 06, 2012 12:35 pm

bobcat2 wrote:Also there is no need to take risk. This stuff about risk as a need is straight from Larry Swedroe who is not an academic. Swedroe is often wrong when he talks about risk and this is one of the many cases where he is wrong about risk.

This was already discussed. But apparently it didn't sink in. So let's do it again.

There is a context about the need to take risk. If you have $2,000,000 in a retirement portfolio and are 65 and are covered by Social Security and a pension and you have gap of only $20,0000 that needs to be covered by the retirement portfolio, then your need to take stock market risk is very low. Maybe all that is needed is a TIPS ladder. That is what is meant by need to take risk.

On the other hand, a person just starting their career has a very small retirement portfolio. If they want it to grow without having to sacrifice too much their current lifestyle (most can likely handle a savings rate of 10 to 20 percent) or the prospect of working to age 70, then there is need to take appropriate stock market risk in order to earn a decent return.
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Fri Apr 06, 2012 2:11 pm

dbr wrote:I think it was an excellent article. Before discussing nuances it is essential to put the fundamentals on the table and be sure they are understood. I think this does that very well.

Thank you dbr! You understand our intent.
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Fri Apr 06, 2012 2:36 pm

I'm surprised at all the challenges to the material we pulled from very basic, introductory standard portfolio theory to illustrate the relationship between uncertainty, risk and return in an introductory article on risk and return. To you folks, again, we are not writing our own book, and have worked very hard not to inject personal bias into this introductory article.

I have added more specific inline references, in the article, to the statements that seem to be generating challenges from those of you who are very knowledgeable on the topic of risk. We have cited credible sources, but since many may not have access to those sources, below are specific quotes from them on which the statements that are generating discussion are based:

“Although graphs help us visualize the dispersion of possible returns, most investors want to quantify this dispersion using statistical techniques. These statistical measures allow you to compare the return and risk measures for alternative investments directly. Two possible measures of risk (uncertainty) have received support in theoretical work on portfolio theory: the variance and the standard deviation of the estimated distribution of expected returns.” Reilly, 1994, p.14

“In the special case that the distribution of returns is approximately normal--represented by the well-known bell-shaped curve--the standard deviation will be perfectly adequate to measure risk. The evidence shows that for fairly short holding periods, the returns of the most diversified portfolios are well described by a normal distribution.” Bodie, Kane, Marcus (BKM), 2008, p.122

“... while standard deviation of returns is a useful risk measure for diversified portfolios, it is not a useful way to think about the risk of individual securities. Therefore the Sharpe measure is a valid statistic only for ranking portfolios; it is not valid for individual assets.” BKM, 2008, p.124

“Now observe the actual historical frequency distributions in Figure 5.1. The variation in the dispersion of the frequency distributions across the different asset classes vividly illustrates the differences in standard deviation and their implication for risk.” BKM, pp. 129,130

Note that our Figure 1 is similar to Figure 5.1 in BKM. Also note that BKM displays figures to two decimal points.

“... we are assuming that the investor is estimating the possible outcomes and the associated probabilities. Often initial estimates of the variance are obtained from historical observations of the assets return.” Elton et al, 2003 p.48

“For well-diversified equity portfolios, symmetrical distribution is a reasonable assumption so variance is an appropriate measure of downside risk … Thus, in most of the portfolio literature the variance, or equivalently the standard deviation, is used as a measure of dispersion.” Elton et al, 2003, p.49 (Note that this was part of a paragraph on justifying the use of variance instead of semivariance).

Hope this helps,

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

Post by Kevin M » Fri Apr 06, 2012 3:20 pm

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.

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

Post by bob90245 » Fri Apr 06, 2012 3:23 pm

Maybe this will covered in part 2. But it seems your figures are bi-model (tri-model?).

Perhaps in the sub-section on Asset Allocation, you can make the point that risk can be somewhat controlled by how much or how little you have in risky and less risky assets. Use a chart like this for illustration:

Image
Source: http://www.fundadvice.com/fehtml/bhstra ... 0309a.html
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Re: Wiki - Investment Risk (revised for new investors)

Post by chaz » Fri Apr 06, 2012 3:29 pm

Kevin M wrote:One of the most fundamental principles a new investor should understand is the relationship between investment risk and investment returns. A team of Boglehead Wiki contributors has collaborated to completely rewrite the Wiki "Risk" article. This article:

  • Uses historical data to demonstrate why stocks are riskier than bonds, and bonds are riskier than cash
  • Explains the relationship between risk and return, a fundamental axiom of investing
  • Explains the principles of managing risk through diversification and asset allocation
  • Provides a brief overview of various types of investment risk

Wiki article link: Risk and return: an introduction

This is the second article included in the Introduction to Investing section of the Bogleheads® investing start-up kit.
The first article in the kit is Bogleheads® investment philosophy, and we recommend that investors new to Bogleheads start there. Our revised "Risk" article is intended for investors who want to expand their understanding of investment risk and its relationship to investment returns.

Comments / questions / concerns are welcome. Investors new to Bogleheads are encouraged to post comments; this article is written for you. Is it too difficult to understand? Did we miss anything?

Thanks!

Kevin (freshman Wikipedia contributor)

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

Post by Kevin M » Fri Apr 06, 2012 3:43 pm

BobK, here's a thought on how we might resolve some of this.

The article under discussion is on investment risk, and is in the Bogleheads® investing start-up kit. It presents the topic primarily based on investment textbooks, both in content and in sequence of topics. The intent is to touch on the most fundamental concepts suitable for an introduction, and not leave any of these concepts out (like the concept of money market securities being treated as risk-free assets, even though there are more advanced ways to look at it). The only reason any fundamental concept might have been left out is to keep it from becoming too complicated.

From what I've read of your writings on risk, not just here but in other posts, it seems to me you are coming at it more from a perspective of financial planning, which is a broader perspective than just investing. Perhaps you could contribute to an article on risk from a financial planning perspective, and include it in the "Bogleheads® personal finance planning start-up kit. I have not looked through that "kit", so don't know if this is covered or not.

Perhaps we could even cross-reference the articles somehow, trying to increase the likelihood that readers will be exposed to broader perspectives on risk (although being a wiki newbie, not sure how this would work).

What do you think?

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

Post by Kevin M » Fri Apr 06, 2012 3:51 pm

chaz wrote:Good work Kevin.

Thanks chaz! I was one member of the team.

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

Post by Kevin M » Fri Apr 06, 2012 3:57 pm

bob90245 wrote:Maybe this will covered in part 2. But it seems your figures are bi-model (tri-model?).

Exactly!

1. Diversify to eliminate unsystematic risk
2. Develop a portfolio of risky assets (somewhere along your curve).
3. Select a mix of "risk-free" assets and your risky portfolio.

As mentioned in the basic article, in practice, Bogleheads tend to use bond funds as the "risk-free" asset, and use one or more stock funds as the risky portfolio.

Thanks!

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

Post by bobcat2 » Fri Apr 06, 2012 4:30 pm

I don't have any problem with using standard deviation as a measure of investment risk. But this is an article written for the novice investor and supposedly you don't want to make it overly difficult.

For the overwhelming majority of novice investors the concept of standard deviation is difficult and applying it to investment returns is even more difficult. If the easiest route to understanding for the novice investor is to begin by talking about standard deviations of statistical distributions, then we are lost. We will be lucky if one out of ten novice investors will understand the material. What's worse, at least half will tune out as soon as you start talking about standard deviations and statistical distributions.

Standard deviation is a statistical measure that often is used to quantify the dispersion (variation) of investment returns,[5][6] which provides a standardized way to compare risk for different investments.[7][8] Note in Figure 1 that the standard deviation increases as dispersion of annual returns increases. Standard deviation of annual returns is most useful for measuring risk over shorter time periods.[9]

For measuring risk over longer time periods, the dispersion of possible cumulative returns is a better measure of risk.
Your asking an awful lot of novice investors if you expect them to understand this material in the intro to investing. Unless the novice investor has a solid handle on basic statistics, this will come across as gibberish.

Conversely some of the material you are leaving out as too advanced is much easier to grasp than discussing the difference between the standard deviation of annual returns as compared to the dispersion of cumulative returns. A classic example of something being important and excluded but easy to understand is the law of one price.

BobK

PS - I know of no reasonable way for the individual to separate her investment plans from her overall financial planning. The household investment plan is an integral part of the household financial plan and cannot in any meaningful sense be separated out from the rest of the financial plan. We cannot have a financial plan over here and an investment plan over there and simply hope that in some sense they will overlap.

If there are those that think household investing is a separate topic from household financial planning then they and I live in two separate financial universes.
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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Fri Apr 06, 2012 4:39 pm

I agree that a real concern is financial planning and that investment planning follows as a part of that. My thought is that the sections on shortfall risk and longevity risk could be fleshed out a little as these are more clear-cut concerns for the real world investor.

Regarding SD, I think the charts in the Wiki are most helpful tin conveying understanding of the underlying idea. I am not that concerned that the article is deficient there.

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

Post by Kevin M » Fri Apr 06, 2012 4:48 pm

bobcat2 wrote:Also there is no need to take risk. There is risk capacity (ability to take on risk) and there is risk tolerance (willingness to take risk) but there is no need to take risk.


The primary references we used are investment textbooks, which are based on the academic literature. The intention was to avoid personal viewpoints, and simply present it the way it's presented in the references.

(my bold)

bobcat2 wrote:This stuff about risk as a need is straight from Larry Swedroe who is not an academic.

Yes, you caught me on that one. I would prefer to use a simple phrase (preferably two words) that captures "how an investor determines how much risk to take" or "how much risk is appropriate for the investor", regardless of what framework is used to evaluate this. I personally use "risk tolerance", but realize this is open to challenge because to some it relates only to the willingness part (e.g., as you say above).

Do you have a suggestion for a simple phrase to use instead?

Would folks object if we just used "risk tolerance", since beginners are unlikely to be aware of the multiple dimensions of assessing how much risk to take?

The intention in the advanced article is to cover various frameworks for evaluating risk, which would perhaps include a textbook approach (like the CFA standard), the approach outlined in the Boglehead's investing book, and frameworks presented in some other books by "Boglehead authors" (including John Bogle himself, and yes, Larry too). For this article it's too much to delve into.

Regarding references, my proposal has been to basically follow Wikipedia policy on credible sources, with the following priority: textbooks, published papers, etc., then Boglehead authors, perhaps giving higher priority to John Bogle and the authors of the Bogleheads Investing and Retirement books (since this is Bogleheads after all), next to other Boglehead authors (W. Bernstein, Swedroe, Ferri, etc.), but also not ignore authors like Swenson, Ilmanen, etc.. Lowest priority would be to online references, since these are not considered credible by Wikipedia; however, they are extremely useful since they are easier for readers to access. The textbooks and papers do not capture everything Boglehead (although they do much of it), so referencing Boglehead books seems appropriate. My hope is to increase rigor in referencing, but most of us are not scholars (I'm certainly not), so it won't be perfect.

On a personal note, I find Larry's framework on risk to be the most useful, which is why I "sneaked it in". When I first read about it some years ago, the "need" part was a huge "aha!" moment for me. It motivated me to help my Dad significantly reduce his equity exposure shortly before the financial crisis, and saved him from the anguish of going through that shortly before he died. It helped me realize that I have little need to take risk, and to structure a portfolio which resulted in reduced anxiety during 2008/2009. I mostly view it more from the perspective of lack of need to take risk, and stress it more for people who have already "won the game" or are close to winning it. I think it's very difficult if not impossible to be highly analytical about determining need to take risk and, as Larry seems to propose.

Also, although Larry does express a point of view, he does seem to keep up on the academic literature, and interpret it for those of us who don't have the chops to understand the papers ourselves. I always keep in mind though that he does tend to take a certain side in the debates, as is evident in the many interesting debates we see in the forum.

bobcat2 wrote:On a more positive note your definition of investment risk is spot-on IMO. :)

Well at least we got one thing right. :wink: You did see my first reply to your first reply where I said I agreed with everything you said, right?

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

Post by Kevin M » Fri Apr 06, 2012 5:40 pm

bobcat2 wrote:I don't have any problem with using standard deviation as a measure of investment risk. But this is an article written for the novice investor and supposedly you don't want to make it overly difficult.

OK, good so far.

bobcat2 wrote:For the overwhelming majority of novice investors the concept of standard deviation is difficult and applying it to investment returns is even more difficult.

I tend to agree with you. This is one reason we're looking for feedback from novice investors here. We've got a tiny bit, but so far it's mostly debate among experienced investors. Looking forward to more feedback from novice investors.

bobcat2 wrote:If the easiest route to understanding for the novice investor is to begin by talking about standard deviations of statistical distributions, then we are lost.

Note that we did not begin with it. We ended the first section with a brief mention of it, with no attempt to explain it. The only intention is to expose the novice investor to the fact that there's a number that is used to measure risk, not to explain how it is calculated or what the statistical implications are. That is done in the advanced article. We could add a sentence or to to clarify this.

In an earlier draft the last two paragraphs of the first section were left out for exactly the reasons you bring up. Hopefully we'll get some feedback from novice investors that will help us decide what makes the most sense. I will try do do some informal surveying of my own.

bobcat2 wrote:We will be lucky if one out of ten novice investors will understand the material. What's worse, at least half will tune out as soon as you start talking about standard deviations and statistical distributions.

We will be lucky if one out of ten novice investors even reads it! The Investment philosophy article covers risk and return at the most basic level, and that is where we suggest investors start. Many of them won't even read that. If they do, maybe that's as far as they'll go. If they move on to the Risk article, hopefully we'll get some feedback from them.

bobcat2 wrote:Your asking an awful lot of novice investors if you expect them to understand this material in the intro to investing. Unless the novice investor has a solid handle on basic statistics, this will come across as gibberish.

You could be right. Hopefully we'll get some feedback from novice investors that will help us decide.

bobcat2 wrote:Conversely some of the material you are leaving out as too advanced is much easier to grasp than discussing the difference between the standard deviation of annual returns as compared to the dispersion of cumulative returns. A classic example of something being important and excluded but easy to understand is the law of one price.

We have simply written an article that presents the introductory material in our primary references in a highly simplified form. It could well be that another article could be written that would be a better next step after the Investment philosophy article. Maybe the current article would be better as a third step. Anyone is welcome to write a different article that they feel is more appropriate as a next step after the Investment Philosophy article.

One thought I had is that perhaps the Financial Planning Start-up kit should come before the Investing start-up kit, and the article you think is more appropriate could be part of the former, so it would be read first.

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

Post by jginseattle » Fri Apr 06, 2012 6:34 pm

That's a very good article. My suggestion would be that you include the term portfolio volatility to frame the discussion when applicable.

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

Post by Kevin M » Fri Apr 06, 2012 6:50 pm

jginseattle wrote:That's a very good article. My suggestion would be that you include the term portfolio volatility to frame the discussion when applicable.

Thanks!

Interesting suggestion, since our emphasis really is on the portfolio, not on individual assets. Where in the article do you think this would fit?

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

Post by LadyGeek » Fri Apr 06, 2012 7:04 pm

My internet is down today, so I'm posting from my Android smartphone. For someone not familiar with the math, it would be simpler to discuss the "shape" of the curves rather than just stating numbers. I have an idea to make the graphs easier to understand, but it will have to wait until I can get.back to my desktop PC.

Editing the wiki is darn near impossible from this browser.

Update: My internet is back.
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Re: Wiki - Investment Risk (revised for new investors)

Post by jginseattle » Fri Apr 06, 2012 7:20 pm

Kevin M wrote:
jginseattle wrote:That's a very good article. My suggestion would be that you include the term portfolio volatility to frame the discussion when applicable.

Thanks!

Interesting suggestion, since our emphasis really is on the portfolio, not on individual assets. Where in the article do you think this would fit?

Kevin


Perhaps when discussing standard deviation and asset allocation.

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

Post by LadyGeek » Fri Apr 06, 2012 7:47 pm

To continue my previous post, my thought on Figure 1 is to use the same charts, but modify the wording to say something like:

Look at the top chart and note how tall the bars are, and that they are spread within a narrow range. This is a chart for Treasury bills, which is another name for a short-term bond.

Next, compare that with the middle chart, which is 10-year bonds (a bond-to-bond comparison). The bars aren't as high and they're spread out a bit more. The interpretation is that the returns varied more year-to-year than the top chart. In other words, you have a higher chance to lose money on your returns as well as gain.

The bottom chart is stocks. Those bars are not only spread out even further apart, but the returns are centered a little higher than the other two charts. The interpretation is that the returns varied a lot more widely year-to-year, but gave a higher return. Therefore, you have the highest chance to lose money; but if you stick it out long enough, you may do better than bonds.

(Update: Revised wording.)
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Re: Wiki - Investment Risk (revised for new investors)

Post by GregLee » Fri Apr 06, 2012 9:08 pm

There is often an uncomfortable ambiguity between "risk" in the artificial sense of investment uncertainty and the everyday sense meaning large chance of loss, or danger. I guess we all know that. But I noticed one place where it comes up in the exposition that is not entirely obvious. After "Other risks applicable to bond investments include: ", you list Call risk, without noting that a bond may have a call price that is above the nominal price of the bond and may perfectly well yield a nice profit to an investor if a bond is called. This is a "risk" in the artificial investment sense, since you are uncertain whether the bond will be called, but the unwary reader may take it to be a danger, even when the uncertainty concerns only whether you will make an extra profit.
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Re: Wiki - Investment Risk (revised for new investors)

Post by stlutz » Fri Apr 06, 2012 10:10 pm

I think the article is overall excellent. Nice work all!

One nit I might pick is the repeated undefined use of "expected return". That's another technical/mathematical term (i.e. the weighted average of possible outcomes) that can either cause eyes to glaze over or lead to misunderstandings like expected return=yield. I always argue for something like "desired return", but I know that's not how it's presented in textbooks so I won't press that here. :D

However, a short parenthetical as to what expected return is might be helpful and would reinforce the point that the actual return and the expected return may likely be quite different. Perhaps something like: "Expected return is simply the average of the possible returns of an investment, taking into account that some outcomes are more likely than others."

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

Post by LadyGeek » Sat Apr 07, 2012 9:13 am

stlutz wrote:"Expected return is simply the average of the possible returns of an investment, taking into account that some outcomes are more likely than others."

:shock:
================
I concur with "desired" return. The idea isn't to replicate a textbook, it's to teach using the knowledge of the forum. Terminology is secondary. If "desired" works, go with it. We can use formal definitions in the forthcoming "advanced" article.
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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Sat Apr 07, 2012 9:53 am

LadyGeek wrote:
stlutz wrote:"Expected return is simply the average of the possible returns of an investment, taking into account that some outcomes are more likely than others."

:shock:
================
I concur with "desired" return. The idea isn't to replicate a textbook, it's to teach using the knowledge of the forum. Terminology is secondary. If "desired" works, go with it. We can use formal definitions in the forthcoming "advanced" article.


Maybe "planned" is a better word than "desired." But to me the crux if the issue is that there are some concepts than which the discussion cannot be made more simple. In other words including the description above of expected return would be a good idea. Quite frankly, if a reader doesn't absorb the gist of that idea, I suspect they will not succeed at investing with understanding at all. That is just a fact of life.

And, I beg to differ, terminology is not secondary. One can read threads on this very forum every day where misunderstanding of terminology has led someone astray and where fuzzy language has produced fuzzy thinking. When there is jargon, which is when words are given a specialized meaning that may be very different from the meaning in ordinary language, then, as above, one should introduce an explanation as soon as possible. Jargon is often an indicator of the existence of one of the fundamental ideas that apply to the discussion.

I also don't agree that conceptually more difficult fundamentals are part of the "advanced" treatment. Fundamentals are sometimes the hardest ideas to teach and learn in the treatment, but without them there is no treatment.

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

Post by LadyGeek » Sat Apr 07, 2012 10:20 am

Good points, I fully agree. It's difficult to determine the learning threshold for "basic" investing knowledge.

Your comments demonstrate where the threshold should be- as it was discussed previously. My prior post was "too simple" and should not be considered.
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Re: Wiki - Investment Risk (revised for new investors)

Post by Barry Barnitz » Sat Apr 07, 2012 10:54 am

Hi:

I have added a footnote, giving stlutz common tongue definition of "expected return".

Originally, as the page was slowly being drafted (by accretion) we had a section devoted to "expected return" :

Risk has been defined as the uncertainty that an investment will earn its expected return, but expected return has not yet been defined (expected return is short for expected rate of return). Informally, this can be thought of as the return on an investment expected by an investor or by a group of investors. Indeed, the term often is used this way by authors of investment books (as seems to be the case, for example, in Expected Returns by Ilmanen.[8]) However, in finance theory expected return has a more precise definition.

An investment's expected return, E(r), is calculated as follows:[9][10]

Various economic scenarios are defined.
Estimates are developed for the probability, p(s), of each scenario occurring and the return, r(s), for that scenario.
The probability and return for each scenario are multiplied together: p(s) x r(s)
The results are summed across all scenarios: p(s1) x r(s1) + p(s2) x r(s2) + ... + p(sn) x r(sn)

Thus, expected return is the weighted average of returns across all possible scenarios.


This was removed as too complex for an introduction to the topic and transferred to a more advanced page.

Originally, we also had a section where we elaborated the same points regarding "risk free" treasury bills as is being discussed. This section include a chart showing the comparative returns between t-bills and inflation over the years 1928- 2011, and included a (collapsible) table in the footnotes with the data. This too was transferred to a work-in progress advanced page.

Money market securities are often referred to as risk-free assets, especially the shorter-maturity securities such as 30-day T-Bills. This is because the short-term return is known with relative certainty at the time the investment is made. There is absolute certainty in the nominal return of a T-Bill (assuming the U.S. government does not default on its obligations), and it is unlikely that unexpected inflation will have significant impact on the real return over a short time period.

If longer time periods are considered, even money market securities have some risk. This is because the effect of unexpected inflation on returns is uncertain over longer time periods. Although money market security rates usually respond relatively quickly to changes in inflation, this is not always the case.

Figure 2 [File:Annual US Treasury Bill Yield and Inflation Rate.jpg - Bogleheads] illustrates the longer-term uncertainty of real returns on 30-day T-Bills. Also, note that the relative certainty of return does not mean that the real return necessarily is positive. It may be known with certainty that a 30-day T-Bill will earn a nominal return of 1% over its 30-day term. However if inflation over the 30-day term is expected to be 3%, the relatively certain expected real return is -2%. [footnotes 1]

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). Of course in return for this reduction in uncertainty, investors must accept lower expected returns. Marketable inflation-indexed securities also have other risks, such as interest rate risk (i.e., prices decline when interest rates rise) and liquidity risk, as was made evident in late 2008 (September 12 - October 31) when the Vanguard Inflation-Protected Securities fund declined in value by almost 14%. During this same time period other U.S. treasury securities increased in value. [6]


As an ancillary note, the performance of t-bills in the forties was a direct result of government interest rate policy, in which government interest rates were price controlled, i.e. "pegged". From Shiller, Can The Fed Control Interest Rates?:

Further evidence on the plausibility of (12) and (13) can be obtained by considering the effects of the Fed’s announcing that interest rates will be pegged at a certain level. Before we consider this, we must point out that this has actually happened. At the end of April 1942 the Federal Open Market Committee directed the twelve Federal Reserve Banks to purchase all treasury bills offered at a discount rate of 3/s of 1 % and in August directed the Federal Reserve Banks to give the seller an option to repurchase bills of the same maturity at the same rate. An ascending rate structure on government bonds was also pegged, peaking at 2.5% for the longest bonds. A demand for short-term bills persisted for a while with this structure, but, as confidence grew that the Fed would continue to peg long rates at this level, it evaporated. In July 1947, the Fed thus ended the peg on treasury bills. In December 1947 the Fed also lowered its buying price to near par on long-term bonds which, with the fixed rate structure, had come to sell above par, but felt obligated not to let bond prices fall below par, until after the Accord in March 1951. Some variation in long-term interest rates was allowed; in particular, the Fed allowed prices of long-term bonds to rise above the pegged price, which happened briefly in early 1946.
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Kevin M
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sat Apr 07, 2012 12:25 pm

stlutz wrote:I think the article is overall excellent. Nice work all!

Thanks!

stlutz wrote:One nit I might pick is the repeated undefined use of "expected return". That's another technical/mathematical term (i.e. the weighted average of possible outcomes) that can either cause eyes to glaze over or lead to misunderstandings like expected return=yield. I always argue for something like "desired return", but I know that's not how it's presented in textbooks so I won't press that here. :D

This is a good point, but at this level, it is OK for readers to think of expected return in whatever way the term brings to mind, such as the return one expects from an investment. It is very common to use the term loosely at first, sometimes even more than at first. Good example is Imanen's book "Expected Returns". You'd think a book with that in the title would explain expected returns in the standard mathematical way, but it does not (at least I could not find it)! The term is simply used without definition, and apparently the meaning is intended to be understood from context.

I suggest we leave it as is unless novice investors indicate confusion.

As Barry said, we went into this in an earlier draft, but it was taken out to keep it simple. The more advanced article has a section that explains it.

Thanks!

Kevin

EDIT: just happened to run across another example of the term being used but not defined--in The Bogleheads Guide to Investing (2006), p.102:
Investors with a short time frame, or who are worried about volatility, should opt for a short-term bond fund. Volatility will be less, but expected return will also be less.
Last edited by Kevin M on Sat Apr 07, 2012 2:16 pm, edited 1 time in total.
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Re: Wiki - Investment Risk (revised for new investors)

Post by YDNAL » Sat Apr 07, 2012 12:40 pm

bobcat2 wrote:I believe a much more fruitful way to approach risk in your intro article is to throw out talk about risk-free and standard deviation. You claim to be making this simple and yet your discussion centers on understanding standard deviation and how standard deviation applies to investment returns. For most novice investors theses are two very complicated ideas.

I thank the contributors for their effort. I also agree with BobK.

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]

The uncertainty inherent in investing is demonstrated by the historical distributions of returns of three major asset classes: cash, bonds, and stocks.[2]

1.↑ Frank K. Reilly, Investment Analysis and Portoflio Management, The Dryden Press, Harcourt Brace College Publishers, Fourth Edition, 1994. ISBN 978-0324171730 (Sixth Edition)
2.↑ Zvi Bodie, Alex Kane, Alan J. Marcus, Essentials of Investments, McGraw-Hill, Seventh Edition, 2008, pp. 129,130. ISBN 978-0073382401
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Re: Wiki - Investment Risk (revised for new investors)

Post by Kevin M » Sat Apr 07, 2012 12:53 pm

YDNAL wrote: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

You could be right. Let's find out!

So far we have not received any feedback from novice investors indicating confusion; only feedback from sophisticated investors telling us that novices will be confused.

If we find that novice investors are indeed confused, we will write a different article for them, and remove this from the start-up kit.

Thanks,

Kevin

p.s. I am thinking of writing an expanded (but still short) introduction that would summarize the topic with simple language, no math, and no charts. This still would be based on one of our primary references, but the intention would be to get the basic ideas across in an intuitive way before diving into the charts and the slightly more expanded explanations.
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Re: Wiki - Investment Risk (revised for new investors)

Post by GregLee » Sat Apr 07, 2012 1:10 pm

Kevin M wrote:You could be right. Let's find out!

So you propose to find out whether novices are confused, by asking them: "Do you find it confusing that in investing, `risk' is used to mean `uncertainty'?". Well, it's good to have a plan, I guess.
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Re: Wiki - Investment Risk (revised for new investors)

Post by dbr » Sat Apr 07, 2012 5:22 pm

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. It would be fine to not call that thing risk but then still proceed to explain the concept. However, one would not think it very hard to show how the fact that returns are uncertain leads directly to the possibility that one can lose money. It is also not hard to show that said uncertainty can lead to shortfall in obtaining a wealth goal. These things are so fundamental, where are they to be addressed if not at the beginning? I also don't think it mind boggling that in a list of various risks in investing one might mention that one can end up anywhere within a range of possible results, quite different from expected. The idea that this uncertainty can mean results better than expected just as well as worse is also very important with respect to understanding what one is seeing in investment results.

Also, I don't think novices are really going to be confused, at least not with language as clear as possible and effective use of figures. I think the figures in the article are pretty good.

This word expected is a real trouble maker. We all know not to be confused that expected doesn't mean anything like promised or certain by contract or something. The word is so commonly used that the bull should be taken by the horns and the concept explained at the get-go.

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