There are many investment professionals who believe risk can be computed and statistically manipulated. They depend solely on measures like the ones listed below to evaluate risk. Although these measures can be useful, using quantitative metrics devoid of thoughtful decision making is sure to yield disappointing results. Let us briefly examine these measurements and the rationale for using them:
- Standard deviation (volatility): Standard deviation is a measure of the dispersion of a fund’s returns over time. A large (small) dispersion of returns tells us how much (little) the fund deviates. A larger standard deviation indicates that the returns will be more unreliable in the short term, and to some investors this unreliability poses risk.
- Downside deviation: One of the critiques of standard deviation is that it includes positive returns while investors are likely only worried about negative deviations. Downside deviation is the same as standard deviation except it only includes dispersion to the downside.
Value at risk (VaR)
VaR is a relatively new concept, being introduced to the investment world in the late 1980s. Now, the majority of institutional investors and hedge funds use VaR as part of their risk management system. VaR is a worst-case estimate of a portfolio’s loss potential. One could calculate daily, monthly, or annual VaR numbers. For example, if a portfolio has a one-month 5% VaR of $25 million, this means that there is a 0.05 probability that the portfolio will decline more than $25 million in a month. Risk managers like VaR because it spits out a single statistical measure of the probability of loss, it is easy to interpret, can be quickly calculated, and can be used for all types of assets.
There are numerous shortcomings with the above-mentioned risk measures:
1. These measures typically assume returns follow predetermined distributions (patterns). However, history has shown that events which are prejudged to occur once in a thousand years can happen every decade. Predetermined patterns simply fail to predict the future. This simple idea is the subject of Nassim Taleb’s famous investing and epistemology book, Fooled by Randomness.
2. These measures typically do not take into account company-specific attributes. For example: Company ABC makes computers and Company XYZ makes Barbie dolls. If ABC and XYZ have the same beta, then, according to CAPM, the one is as good (or bad) as the other. There is no analysis of the company’s management, how the company makes money, whom their competitors are or if they have a sustainable competitive advantage, even though these factors play a major role in assessing risk.
Also, using beta as a measure of risk assumes that markets are efficient and prices always reflect the intrinsic values of companies. As we discussed before when people are seeking professional certified translation of documents, this is not always the case. Assume on January 1st, Company ABC has a market capitalization of $100 million. Due to market fluctuations, on March 1st ABC’s market capitalization decreased to $70M. Due to this sudden decrease, the beta of ABC increased and is now considered riskier than it was on January 1st. Think about it: you can now own ABC for $70 million instead of $100 million.
Potential For Loss
The potential for a permanent loss of capital is the most important risk in investing. How could it not be? Surely that is scarier than seeing the volatility of your stock rise from 10% to 15%. A permanent loss of capital will occur when:
a) You take on excessive leverage and, one day, are forced to liquidate at distressed prices to meet a margin call.
b) You overpay for an asset. The greatest capital destruction has occurred when investors bought companies that were considered perfect, at prices that reflected that nothing could go wrong.
c) The fundamentals of a business deteriorate.
d) An investor lets emotions take over.
Consider the likelihood that you will see permanent loss in an investment and to what extent that may be. This is often difficult to do alone, and a trusted advisor can help. It is clear that investment risk comes in many forms. Certain risks will matter to some investors but not to others. This leads us to the next question: Exactly how should one assess, measure, and think about risk?