Considerable mathematical analysis of investments and portfolio construction rests on the acceptance of standard deviation as a measure of investment risk. Once accepted, mean-variance analysis takes center stage to generate optimal portfolios and eventually arrive at an elegant presentation of the "Efficient Frontier" and a focus on the asset allocation issue.
But for many, the acceptance of standard deviation as a proxy for risk is not straight forward. They argue that risk is about losing money, about downturns in the market, and about running out of money - not about returns that are significantly higher and lower than average.
William Bernstein emphasizes the different ways of looking at risk in The Intelligent Asset Allocator.
Incidently, this is one of the first books (along with Random Walk Down Wall Street by Malkiel) that I recommend to people who indicate a serious interest in the subject of investing.
The very foundations of investment theory, of course, rests on the crucial trade-off between risk and return. In this light, consider the following table (1964 study by Paul Miller) presented on page 116 of The Intelligent Asset Allocator:
The interesting point of the table, however, is that it also shows additional measures of risk; and these measures are not as cooperative to the theory. The number of losing years and the number of years where the loss exceeds 10% are both less for the "riskier" low p/e stocks! With these measures, a higher return was achieved with less risk.
This points to one of the values of utilizing a total market index, in that it automatically gets an investor to hold stocks that are deemed unattractive, i.e. have low p/e ratios.
Thoughts and observations for those investing on their own or contemplating doing it themselves.
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Thursday, June 9, 2011
How to Measure Investment Risk?
Posted by Robert Wasilewski at 7:40 AM
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Very interesting post. Risk is certainly a difficult concept to quantify and measure. I doubt there will ever be widespread agreement on all the details.ReplyDelete
In my opinion standard deviation is an imperfect measure of risk because it ignores correlation with other events in the world. I might pay a premium for a high standard deviation investment which had a negative correlation to the overall economy because I would view it as insurance, but I would require a high expected return to invest in a similar investment with the same standard deviation but with a positive correlation to the overall economy.
However, I'm skeptical when I hear investors say they think standard deviation is a poor risk measure because they are only concerned about losing money due to downside risk. I don't think most investors are truly risk neutral on the upside...I think Fama and French summarize it well in this discussion: http://www.dimensional.com/famafrench/2010/04/qa-semi-variance-a-better-risk-measure.html#more
I would like to reiterate the recommendation of the intelligent asset allocator. I really enjoyed reading this book and it quickly introduces the average lay man to the world of investing.ReplyDelete
re: Chad Good points about correlation and expected return. I guess I'm saying that sometimes I think we've taken some shortcuts when it comes to thinking about and specifying risk in the investment process.ReplyDelete
re: Mich The book is well worth reading actually a few times because makes some subtle, astute points. I've often struggled however with the recommendation in his and similar books about the dominance of the 5 year Treasury over the longer term Treasury. He almost says forget the longer term issue but I know there have been periods where the longer term issue has been clearly dominant. I've got to break away some time and dig into his data. Otherwise I'm a big fan.
Great book, should be required reading for the individual investor.ReplyDelete
Thanks for making things clear. This topic gives me headaches for quite sometime already. I am really glad you shared this information.ReplyDelete