measurement of risk

[Bubblesofearth]

What do people on here mean when they use the term 'risk' as applied to investments and how do they quantify it?

I'm asking this because 'risk' has been invoked numerous times on different boards recently but it's unclear (to me at least) what is intended.

There is the recognised industry standard of standard deviation as a measure of volatility risk but I get the impression a lot of the time this is not what is being referred to.

Hence my question as to what people hereabout mean by risk and how they quantify it?

BoE

[Itsallaguess]

What do people on here mean when they use the term 'risk' as applied to investments and how do they quantify it?

I'm asking this because 'risk' has been invoked numerous times on different boards recently but it's unclear (to me at least) what is intended.

There is the recognised industry standard of standard deviation as a measure of volatility risk but I get the impression a lot of the time this is not what is being referred to.

Hence my question as to what people hereabout mean by risk and how they quantify it?

It's been an interesting couple of weeks on this particular discussion elsewhere, and I'll link below to two polar-opposite posts that highlight what for me has been at least one aspect that's stood out regarding 'concentration risk' -

The whole point of sectoral and share diversification on purchase is an acknowledgement that you don't know where the big winners are going to come from that will drive portfolio growth. All portfolios, as well as whole markets , evolve this way. As I've pointed out repeatedly on these boards, markets are asymmetric. Growth of both capital and dividends comes from a relatively small number of components. Leave them alone to do their thing.

https://www.lemonfool.co.uk/viewtopic.php?f=31&t=41482&p=632236#p632149

The risk increases as the index becomes more concentrated. Arguably this is the large companies getting larger, though it could equally be due to the small companies getting smaller. However neither change the fact that you are becoming more dependent upon a few given companies.

https://www.lemonfool.co.uk/viewtopic.php?f=55&t=41717&p=634450#p634322

The first post above is one of yours, discussing the huge concentration-imbalances in HYP1, and the second one is from Urbandreamer, who's discussing company-weightings within a given market index.

Given that those two views seem to take opposite sides on the same issue, then perhaps they might form the basis of at least one aspect of the type of 'risk' that's been regularly discussed in recent times on these boards...

Cheers,

Itsallaguess

[GoSeigen]

When you buy a bond with a modified duration matched to your investment timeline you maximise the probability that you will achieve the purchased yield.

Risk is the various events that may result in failure to achieve this yield.

Similar with other assets or a portfolio of assets.

I don't think it needs to be much more complicated than that.


GS

[Steveam]

Risk and volatility are not (in common usage) the same thing. When talking about minimising the risk most people do not mean minimising volatility.

Mathematics (and finance) are precise; common usage is often imprecise.

Best wishes, Steve

[Urbandreamer]

What do people on here mean when they use the term 'risk' as applied to investments and how do they quantify it?

I'm asking this because 'risk' has been invoked numerous times on different boards recently but it's unclear (to me at least) what is intended.

There is the recognised industry standard of standard deviation as a measure of volatility risk but I get the impression a lot of the time this is not what is being referred to.

Hence my question as to what people hereabout mean by risk and how they quantify it?

It's been an interesting couple of weeks on this particular discussion elsewhere, and I'll link below to two polar-opposite posts that highlight what for me has been at least one aspect that's stood out regarding 'concentration risk' -

The whole point of sectoral and share diversification on purchase is an acknowledgement that you don't know where the big winners are going to come from that will drive portfolio growth. All portfolios, as well as whole markets , evolve this way. As I've pointed out repeatedly on these boards, markets are asymmetric. Growth of both capital and dividends comes from a relatively small number of components. Leave them alone to do their thing.

https://www.lemonfool.co.uk/viewtopic.php?f=31&t=41482&p=632236#p632149

The risk increases as the index becomes more concentrated. Arguably this is the large companies getting larger, though it could equally be due to the small companies getting smaller. However neither change the fact that you are becoming more dependent upon a few given companies.

https://www.lemonfool.co.uk/viewtopic.php?f=55&t=41717&p=634450#p634322

The first post above is one of yours, discussing the huge concentration-imbalances in HYP1, and the second one is from Urbandreamer, who's discussing company-weightings within a given market index.

Given that those two views seem to take opposite sides on the same issue, then perhaps they might form the basis of at least one aspect of the type of 'risk' that's been regularly discussed in recent times on these boards...

Cheers,

Itsallaguess

I'm not actually sure that Bubblesworth and I are on different sides. My comment was upon a thread about the risk of loss. Bubblesworth is talking about the flip side, the "risk" of gain.

Which is important to an investor differs between investors.

My post is from the passive investment board and I'm careful what I say there. I don't want to wind up in a bun fight just because I'm an active investor.
As an active investor I consider risk/reward a lot. Currently I'm drifting towards reduced risk, however in the past I slanted my choices towards reward.

I happen to think that passive investors should consider risk, and be active enough to make decisions about it. Like for example choosing an index that is equal weighted or constrains constituents to no more than 5% of the index, or using multiple indices to achieve global coverage without being a closet S&P tracker.

However that is anathema to some.
I would imagine that considering risk is also anathema to "some" hard line "no tinkering" HYP proponents. I've got into bun fights on that board too, as I no longer follow HYP, hence must be wrong.

The "standard" definition used in risk assessment is a multiplication of likely hood with severity of the downside. This very much slants things when considering investment. I'd argue that the component due to the severity of downside needs adjusting based upon the investors ability to cope with said downside. Further adjustments should be made to balance risks between investments. Which is where this concentration of sectors becomes a serious consideration.

If gains are the target you want a concentrated portfolio. If wealth preservation is your thing then you want to avoid that.

As you and Bubbleworth know I have a small amount of bitcoin. It's low risk.
WHAT WHY?
Well it may be volatile as hell but losses wouldn't cause any issue. The flip side is that any gains would make no difference to me. Hence low risk.
It's also uncorrelated with either the pound or the stock market.
You can see why I argue that it's low risk, though I know that the pair of you regard it as very risky and wouldn't touch it with a barge pole.

[tjh290633]

My view is that risk implies either loss of capital or of income, or both. You could apply a probability of each occurring for each share or bond in your portfolio.

Experience tells us that loss of capital can be related to movements in the market, where rises or falls do not affect all shares equally. I had a number of shares which emulated the Oozlum bird, like Marconi, Mapeley, Cattles and Carillon. That's four this century so far. Do we assume that the probability is one every 6 years? That's in a portfolio ranging from 25 to 37 holdings.

Loss of income from shares has been more frequent, most notably after the 2008 GFC when I experienced a fall of over 50%. Fortunately not a frequent occurrence. Those with a portfolio of ITs have probably had a happier experience as there are a number of ITs with a record of increasing dividends for many years. This they do by drawing on reserves. I tend to mark each declared dividend with a green background if it is increased, white if unchanged, yellow if reduced and red if cancelled. I could go back over the years to establish the probability of reduction or cancellation. With 30-odd holdings, that is about 70 payments each year, as some pay quarterly. 2010 was the worst year with very few green or white cells. Currency movements are another factor. Probably best to use the declared dividend in the currency in which the company does it's accounts.

Taking all in all, my guess is that the probability of a company failure is of the order of 4 in 30 in 24 years. About 4/720.

For loss of dividends we are looking at higher numbers, which needs more research on my part.

Food for thought.

TJH

[Wuffle]

I would consider risk to be about performance comparisons to a wider world.
The accumulated pile has a job to do, to provide for you. This will reduce to a bidding war against everyone else.
A comparison to the most widely held stuff should come into it somewhere.
A car or a hotel room in a capital city is a proxy to global average returns.

W.

[Itsallaguess]

As you and Bubbleworth know I have a small amount of bitcoin. It's low risk.

WHAT WHY?

Well it may be volatile as hell but losses wouldn't cause any issue. The flip side is that any gains would make no difference to me. Hence low risk.

It's also uncorrelated with either the pound or the stock market.

You can see why I argue that it's low risk, though I know that the pair of you regard it as very risky and wouldn't touch it with a barge pole.

Well, yes...

Perhaps you could caveat all your pro-Bitcoin posts with that clear caveat, and then anybody reading them would understand completely where your actual personal exposure to the cryptocurrency lies...

Cheers,

Itsallaguess

[Adamski]

I look at Standard Deviation, the greater the SD, the more the price volatility, the greater the risk.

Lots of us have had rollercoaster ride with stock market bubbles going burst. Most recently the popular Baillie Gifford funds. Back in pandemic, remember seemed like every day SMT would go up 2,3%. The narrative at the time is always, "things this time are different. It has have changed". But with hindsight obvious was a bubble forming.

Now it's the magnificent 7, Nvidia, Telsa >100% this year. Bitcoin likewise. The same psychology plays over again and again. Hence the needs to spread risk and diversify.

[Urbandreamer]

Well, yes...

Perhaps you could caveat all your pro-Bitcoin posts with that clear caveat, and then anybody reading them would understand completely where your actual personal exposure to the cryptocurrency lies...

Cheers,

Itsallaguess

There are strong privacy issues involved, but for what it's worth:

I don't mind admitting to being 0.41% in bitcoin (See post in reply to Robertbanking about portfolio content).
viewtopic.php?p=633749#p633749
I would be willing to invest up to 2%, but would start reducing my holding if it grew to above 6-8%.

Just as I sold part of my SMT holding when it grew to above 12% of my portfolio.
viewtopic.php?p=383814#p383814

Still enough about bitcoin. This is a general investment board and we were discussing managing risks. Not damning or praising a given holding.

[simoan]

I look at Standard Deviation, the greater the SD, the more the price volatility, the greater the risk.

First you have to define what risk is. Risk is not volatility. The risk that investors in the financial markets are concerned with is the risk of permanent loss of capital. Risk is ever present, multi-layered and cannot be quantified because you can never mitigate against risks you are not aware of, such as a Black Swan. The best explanation of risk I have read is the memos by Howard Marks on the subject: https://www.oaktreecapital.com/docs/def ... isited.pdf

[Bubblesofearth]

OK, I obviously didn't word my question clearly enough. What I'm looking for are two one-liners;

1. A definition of risk.

2. How to quantify that risk.

Apart from Adamski, who is happy with the industry standard of volatility, no-one else has provided the above two statements. We've had, for example, risk of permanent loss of capital as a definition but how is that quantified?

The reason this is important is to minimise misunderstandings. If a definition is too vague, or not quantified, then it opens itself to disagreement without any yardstick to say who is right or wrong. For example, during one discussion around HYP1, some people regard the imbalance as too risky whilst others accept it. Without a clear definition of exactly what the risk is and how to quantify it you can end up in a situation where both parties feel they are right even if diametrically opposed. You can also end up going round in endless circles!

So a line for the definition and a line for how to quantify it please. The first of of little value without the second IMO.

BoE

[Itsallaguess]

What I'm looking for are two one-liners;

1. A definition of risk.

2. How to quantify that risk

So a line for the definition and a line for how to quantify it please.

I don't think it's possible to simplify something that's so personally context-driven like that when it comes to investment.

Cheers,

Itsallaguess

[Steveam]

OK, I obviously didn't word my question clearly enough. What I'm looking for are two one-liners;

1. A definition of risk.

2. How to quantify that risk.

Apart from Adamski, who is happy with the industry standard of volatility, no-one else has provided the above two statements. We've had, for example, risk of permanent loss of capital as a definition but how is that quantified?

The reason this is important is to minimise misunderstandings. If a definition is too vague, or not quantified, then it opens itself to disagreement without any yardstick to say who is right or wrong. For example, during one discussion around HYP1, some people regard the imbalance as too risky whilst others accept it. Without a clear definition of exactly what the risk is and how to quantify it you can end up in a situation where both parties feel they are right even if diametrically opposed. You can also end up going round in endless circles!

So a line for the definition and a line for how to quantify it please. The first of of little value without the second IMO.

BoE

It really is worth reading the Howard Marks memo to investors linked by Simoan above. I read it years ago and am pleased to be re-acquainted with it. I’m tempted to try to summarise but I’d do Marks a dreadful disservice.

I’m really trying to be helpful so please don’t take this amiss - it’s really not easy to take a subject such as risk and reduce it to a couple of lines.

Best wishes, Steve

[Bubblesofearth]

It really is worth reading the Howard Marks memo to investors linked by Simoan above. I read it years ago and am pleased to be re-acquainted with it. I’m tempted to try to summarise but I’d do Marks a dreadful disservice.

I’m really trying to be helpful so please don’t take this amiss - it’s really not easy to take a subject such as risk and reduce it to a couple of lines.

Best wishes, Steve

I've had a look at the article and thanks for that (and to Simoan of course for linking it). The essence of what is said makes a lot of sense even if it takes us to a place where non-volatility risk is unquantifiable.

The issue of course is that so many threads on TLF contain statements about risk. Without any quantification these statements are purely qualitative and, for the most part, subjective. So maybe the question is more about how to get to consensus rather than quantification? How to avoid endless an unproductive discussion about different perceptions of the same risk?

Take the statement 'what investors fear is permanent loss of capital'. If one person deems this to be low for a particular investment whilst another sees it as high who is to say which view is correct? It might come down to different time horizons but what if all factors pertaining to the two investors are equal? Without being able to quantify the risk how can anyone say who is right?

BoE

[moorfield]

The reason this is important is to minimise misunderstandings. If a definition is too vague, or not quantified, then it opens itself to disagreement without any yardstick to say who is right or wrong. For example, during one discussion around HYP1, some people regard the imbalance as too risky whilst others accept it. Without a clear definition of exactly what the risk is and how to quantify it you can end up in a situation where both parties feel they are right even if diametrically opposed. You can also end up going round in endless circles!

I think you have to have a common agreement on what the yardstick is first, before you get into those questions.

I don't think many people would disagree that the minimum acceptable performance of HYP1 would be to preserve the spending power of that initial £3,451. 22 years later that would be £6,776 (I am using RPI/CHAW here https://www.ons.gov.uk/economy/inflatio ... /chaw/mm23). HYP1 produced £11,123 that year, RIO contributing ~27%. Does that make it "risky" ? The yardstick would suggest not at all, as indeed this year's income collapse to £7,729 has shown - it is still ahead.
And yet in year 3, with a more equally balanced portfolio which certainly didn't look as "risky" as it might look now, its income fell 8%, well short of yardstick.

All risks then are relative. But relative to what?

[NotSure]

The reason this is important is to minimise misunderstandings. If a definition is too vague, or not quantified, then it opens itself to disagreement without any yardstick to say who is right or wrong. For example, during one discussion around HYP1, some people regard the imbalance as too risky whilst others accept it. Without a clear definition of exactly what the risk is and how to quantify it you can end up in a situation where both parties feel they are right even if diametrically opposed. You can also end up going round in endless circles!

I think you have to have a common agreement on what the yardstick is first, before you get into those questions.

I don't think many people would disagree that the minimum acceptable performance of HYP1 would be to preserve the spending power of that initial £3,451. 22 years later that would be £6,776 (I am using RPI/CHAW here https://www.ons.gov.uk/economy/inflatio ... /chaw/mm23). HYP1 produced £11,123 that year, RIO contributing ~27%. Does that make it "risky" ? The yardstick would suggest not at all, as indeed this year's income collapse to £7,729 has shown - it is still ahead.
And yet in year 3, with a more equally balanced portfolio which certainly didn't look as "risky" as it might look now, its income fell 8%, well short of yardstick.

All risks then are relative. But relative to what?

Trying to assess risk based on a specific portfolio, in retrospect, it not that helpful in my extremely humble opinion. Risk is a forward looking thing.

In general, risky portfolios will make more (often much more), on average, than safe ones. the problem in, that due to volatility, your chances of buying high the being obliged to sell low are increased. By industry standards, money market funds are risk = 1. Your capital be be preserved, but your gain will (tend to be) very limited. On the other hand, concentrated portfolios, e.g. SMT (risk = 7) will tend to have much higher gains, on average, but may also destroy your capital.

The risk in that in your specific case, due to timing, you may do very poorly,. If you horizons are long and flexible, take that risk. If they are shorter and inflexible, beware. If you're a punter, take that risk anyway.

As it was conceived, HYP was "pretty risky". UK only, 100% equity (risk ~ 6/7). So one would expect good results if time was on your side, but if saving for a house down payment, then for the very risk tolerant only. HYP1 now is , IMEHO, very high risk. Very, very concentrated, So may go gangbusters, but may do very badly indeed.

Risk is good in terms of potential return, but bad in terms of worst case scenarios (your money market fund wont blow the lights out, but nor will in destroy your capital) HYP/SMT may well blow the lights outs, but the risk it will fail very badly is very much present.

So if you are young and/or loaded, take risk! If not, perhaps be a bit more careful... But on the whole, taking risk does pay off.

edit - minor typos

[GeoffF100]

I had a look at the paper linked by simoan. A lot of what the author says is true, but he does seem to misunderstand the nature of volatility and its mathematical consequences. It is not as benign as he presents it. If the market falls by 50% as result of volatility, other things being equal, the chance of it recovering back to where it was are the same as the chance that it will fall another 50%. Volatility is not just bobbling up and down. It can wipe you out.

An important related issue is whether the risk of holding the market decreases with time. If it has a positive growth rate (which is by no means guaranteed), the chance of it ending up below a fixed level decreases with time. Many people (particularly those who post on boards like these) are keen to say that means that the risk of holding the market reduces with the passage of time, but that is not the whole story.

The cost of insuring against loss, by buying a put option, increases with time. How can that be? I read a book by a guy who claimed that the pricing of put options was wrong because the Black-Scholes formula (which won the Nobel Prize for Economics) did not take account of the stock growth rate. That is incorrect. If you look at the derivation of the formula you will see that it does take account of the stock growth rate, but it cancels out and does not appear in the formula itself. It is a long time since I went through the mathematics, but it all has to do with risk neutral valuation. That is based on the assumption that it is equally desirable to hold the stock or to hold a risk free bond. That is the perspective of a big investment bank that has big portfolios of both. If the stock were more desirable then people would buy it and push the price up, making it less desirable. Likewise for the bond.

Equity fans are usually horrified by this, and meet it with denial and disbelief. Nonetheless, it is a consequence of random volatility. Volatility is not so benign. Of course if you really believe that this is wrong, you can bet against it on the options market. You can sell very long dated put options on the US market (they are called Leaps), using stocks as collateral. Rather you than me though.

[JohnW]

But on the whole, taking risk does pay off.

I agree with the sentiment of that post, but I think that pithy conclusion can lead the naive astray. If taking risk were to always pay off, then it's not risky. Taking risk is risky exactly because it sometimes doesn't pay off. 'on the whole' is where the potential misguidance for beginners lies.

[Urbandreamer]

I had a look at the paper linked by simoan. A lot of what the author says is true, but he does seem to misunderstand the nature of volatility and its mathematical consequences. It is not as benign as he presents it. If the market falls by 50% as result of volatility, other things being equal, the chance of it recovering back to where it was are the same as the chance that it will fall another 50%. Volatility is not just bobbling up and down. It can wipe you out.

I have to disagree. Indeed I have to disagree strongly.

YES, if you are betting upon a coin you are right. Companies (groups of people) are not coins!

Fairly recently we had a serious event that caused the market to fall in excess of 30%.
Sure it could not be predicted, and in that sense it was random.
However the recovery?

Are you actually arguing that we were likely to have another pandemic on top of Covid?

In fact, while the causes of the volatility can't be predicted, they are NOT random. There ARE causes. Not only are there causes, but human nature is to respond to them. To work both to ameliorate the impact and to ensure preparedness for similar future events.

Are you actually arguing that a pandemic is likely WHILE quarantine lock downs are in place?

OK, forget Covid and talk the financial crash. Now I happen to think that we still have what is called a "moral hazard" in the financial system. But you seem to claim that actions of the state can have had no effect to prevent such an event happening tomorrow.

We are not dealing with a simple random number generator!