More on risk

We defined risk as the chance of losing money when you sell your investment. We need to make 2 refinements to this working definition.

1. In investments, risk is defined more broadly as the chance of receiving a return that is different from the return we expected to make.

Risk, in fact, includes not only bad outcomes such as lower than expected returns, but also good outcomes like higher than expected returns.

Thus, if the expected returns of an investment is 5%, the risk that you will earn a 10% return or 0% is exactly the same. In other words, using standard deviation, you do not distinguish between downside risk and upside risk.

For this reason, some investors may not be completely comfortable with standard deviation as a measure of risk.

They may go for:

• a measurement called the semi-variance where only returns that fall below the expected return are considered.
• they may go for simpler yet common-sensical proxies for risk. For example, it makes sense that stocks of technology companies are riskier than those of food companies. Others prefer to create ranking categories. (For example, ranking money market instruments as lower risk and technology stocks at higher risk.)

2. There are also investments whose expected return is known ahead of time.

For example, when you buy a bond that pays a fixed interest payment every six months and the return of principal at maturity, you can tell ahead of time what your actual return will be.

The risk is not in our stocks, but in ourselves

Risk exists in another dimension: inside you.

If you want to know what risk really is, go to the nearest bathroom and step up to the mirror. That's risk, gazing back at your from the glass.

If you overestimate how well you really understand an investment, or overstate your ability to ride out a temporary plunge in prices, it doesn't matter what you own or how the market does.
Ultimately, financial risk resides not in what kinds of investments you have, but in what kind of investor you are.

The Nobel-prize-winning psychologist Daniel Kahneman explains two factors that characterize good decisions:

1. Do I understand this investment as well as I think I do? ("Well-calibrated confidence")

2. How will I regret if my analysis turns out to be wrong? ("Correctly-anticipated regret")

To find out whether your confidence is well-calibrated, look in the mirror and ask yourself: "What is the likelihood that my analysis is right?" Think carefully through these questions:

• How much experience do I have? What is my track record with similar decisions in the past?
• What is the typical track record of other people who have tried this in the past?
• If I am buying, someone else is selling. How likely is it that I know something that this other person (or company) does not know?
• If I am selling, someone else is buying. How likely is it that I know something that this other person (or company) does not know?
• Have I calculated how much this investment needs to go up for me to break even after my taxes and costs of trading?

Next, look in the mirror to find out whether you are the kind of person who correctly anticipates your regret. Start by asking: "Do I fully understand the consequences if my analysis turns out to be wrong?" Answer that question by considering these points:

• If I'm right, I could make a lot of money. But what if I'm wrong? Based on the historical performance of similar investments, how much could I lose?
• Do I have other investments that will tide me over if this decision turns out to be wrong? Do I already hold stocks, bonds, or funds with a proven record of going up when the kind of investment I'm considering goes down? Am I putting too much of my capital at risk with the new investment?
• When I tell myself, "You have a high tolerance for risk," how do I know? Have I ever lost a lot of money on an investment? How did it feel? Did I buy more, or did I bail out?
• Am I relying on my willpower alone to prevent me from panicking at the wrong time? Or have I controlled my own behaviour in advance by deversifying, signing an investment contract, and dollar-cost averaging?

"Risk is brewed from an equal dose of two ingredients - probabilities and consequences."

Before you invest, you must ensure that you have realistically assessed

• your probability of being right and
• how you will react to the consequences of being wrong.

What is risk? First, don't lose

What is risk? You will get different answers depending on whom, and when, you ask.

In 1999, risk didn't mean losing money; it meant making less money than someone else! What many people feared was bumping into somebody at a barbecue who was getting even richer even quicker by day trading dot-com stocks than they were.

Then, quite suddenly, by 2003 risk had come to mean that the stock market might keep dropping until it wiped out whatever traces of wealth you still had left.

While its meaning may seem nearly as fickle and fluctuating as the financial markets themselves, risk has some profound and permanent attributes. The people who take the biggest gambles and makes the biggest gains in a bull market are almost always the ones that get hurt the worst in the bear market that inevitably follows. (Being "right" makes speculators even more eager to take extra risk, as their confidence catches fire.)

And once you lose big money, you then have to gamble even harder just to get back to where you were, like a race-track or casino gambler who desperately doubles up after every bad bet. Unless you are phenomenally lucky, that's a recipe for disaster.

First, don't lose

No wonder, when he was asked to sum up everything he had learned in his long career about how to get rich, the legendary financier J.K. Klingenstein of Wertheim & Co. answered simply: "Don't lose."

Losing some money is an inevitable part of investing, and there's nothing you can do to prevent it. But, to be an intelligent investor, you must take responsibility for ensuring that you never lose most or all of your money.

For the intelligent investor, Graham's "margin of safety" performs an important function. By refusing to pay too much for an investment, you minimize the chances that your wealth will ever disappear or suddenly be destroyed.

"Imagine that you find a stock that you think can grow at 10% a year even if the market only grows 5% annually. Unfortunately, you are so enthusiastic that you pay too high a price, and the stock loses 50% of its value the first year. Even if the stock then generates double the market's return, it will take you more than 16 years to overtake the market - simply because you paid too much, and lost too much, at the outset."


Ref: Intelligent Investor by Benjamin Graham

Types of Risk (Total risk = Unique risk + Market risk)

Modern portfolio theory looks at risk from a different perspective. It divides total risk as follows:

Total risk = Unique risk + Market risk

Unique risk (Diversifiable risk or Unsystematic risk)

The unique risk of security represents that portion of its total risk which stems from firm-specific factors like

• the development of a new product,
• a labour strike, or
• the emergence of a new competitor.

Events of this nature primarily affect the specific firm and not all firms in general.

Hence, the unique risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio, unique risks of different stocks tend to cancel each other - a favourable development in one firm may offset an adverse happening in another and vice versa.

Hence, unique risk is also referred to as diversifiable risk or unsystematic risk.

Market risk (Non-diversifiable risk or Systematic risk)

The market risk of a stock represents that portion of its risk which is attributable to economy-wide factors like

• the growth rate of GDP,
• the level of government spending,
• money supply,
• interest rate structure, and
• inflation rate.

Since these factors affect all firms to a greateror lesser degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be.

Hence, it is also referred to as systematic (as it affects all securities) or non-diversifiable risk.

Risk

You cannot talk about investment returns without talking about risk because investment decisions invariably involve a trade-off between the two.

Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome.

More specifically, most investors are concerned about the actual outcome being less than the expected outcome.

The wider the range of possible outcomes, the greater the risk.


Sources of Risk

Risk emanates from several sources. The three major ones are:

1. business risk,

http://myinvestingnotes.blogspot.com/2008/09/business-risk.html

2. interest rate risk, and

http://myinvestingnotes.blogspot.com/2008/09/interest-rate-risk.html

3. market risk.

http://myinvestingnotes.blogspot.com/2008/09/market-risk.html

Types of Risk

Modern Portfolio Theory looks at risk from a different perspective. It divides total risk as follows:

Total risk = Unique risk + Market risk

http://myinvestingnotes.blogspot.com/2008/09/types-of-risk-total-risk-unique-risk.html

Risk and Return - Two Sides of the Investment Coin

Investment decisions are influenced by various motives.

Some people invest in a business to acquire control and enjoy the prestige associated with it.

Some people invest in expensive yatchs and famous villas to display their wealth.

Most investors, however, are largely guided by the pecuniary motive of earning a return on their investment.

For earning returns investors have to almost invariably bear some risk.

In general, risk and return go hand in hand.

While investors like returns they abhor risk.

Investment decisions, therefore, involve a tradeoff between risk and return.

Since risk and return are central to investment decisions, we must understand what risk and return are and how they should be measured.