Measuring Risk

[jay21]

I believe the goal of every investor is to try to obtain the highest risk adjusted returns.  It is usually easy to identify a practitioner's returns by looking at their track record.  However, this does not take into account the risk taken to achieve those returns.

 

We often say what risk is not (It is not: Beta, volatility, etc.), but how do we assert what risk is?  How can we measure it?  How objective are we when reviewing past investments and their associated risks?  Does your perception of the risk change now that you know the outcome (if anyone has an example of an investment that worked out, but their perception of the risk increased after the fact, I would love to hear about it)? 

[Palantir]

I'm pretty sure risk IS volatility. What other concept of risk is there? We had this discussion a few weeks ago, but even measures like shortfall risk etc use volatility as an input. As one poster stated on that thread, risk can be seen as the asset's true standard deviation....but that's obviously unknown.

 

 

What Birdman is referring to is a totally different type of risk. Operational risk is important, but it is not the same as the market risk of an investment.

[NormR]

I'm pretty sure risk IS volatility.

 

There aren't many people who don't like upside volatility. 

 

I like Marty Whitman's idea that risk should always be qualified with an adjective.  The search for one unifying risk measure is likely futile and perhaps dangerous if it stops people thinking about the different risks they face.

[LC]

I think Risk is very difficult to measure accurately. I think it's easy to fool myself into thinking what "risk" is. Permanent loss of capital is a strong definition, but as you can imagine it is a very general definition.

 

The way I define it to myself is that risk is "the potential of a business to lose value".

[zarley]

I'm pretty sure risk IS volatility.

 

There aren't many people who don't like upside volatility. 

 

I like Marty Whitman's idea that risk should always be qualified with an adjective.  The search for one unifying risk measure is likely futile and perhaps dangerous if it stops people thinking about the different risks they face.

 

Amen. 

 

There are many kinds of risk; most are not measurable in any real way.  Ex ante, you're lucky to understand them in a very general way.

[Palantir]

I'm pretty sure risk IS volatility.

 

There aren't many people who don't like upside volatility. 

 

 

Not true. Take an asset that has only upside volatility, and compare it to an asset with equal expected return and no deviation in return (essentially a risk free asset with same E® ). You would prefer the volatile asset? I would not. On the other hand, if by upside volatility you mean volatility above the mean, then the asset would have a higher E®...above the RF asset...

 

Upside volatility is not separable from Risk, and not a meaningful concept, if I understand you correctly, you're looking at the positive side of the distribution and saying "This part is good", but the "good" side also comes with a "bad" side that WILL balance it out to equal E®. You have a dispersion of outcomes, and to an asset holder, given the same expected return, you want the asset with a smaller dispersion...

[mcliu]

When you say volatility, are you talking about price volatility, or cash flow (or value) volatility?

 

If you're referring to historical price volatility as the risk of a stock, I would disagree unless the price perfectly reflects the value of the business.

[JBird]

I'm pretty sure risk IS volatility. What other concept of risk is there? We had this discussion a few weeks ago, but even measures like shortfall risk etc use volatility as an input. As one poster stated on that thread, risk can be seen as the asset's true standard deviation....but that's obviously unknown.

 

 

What Birdman is referring to is a totally different type of risk. Operational risk is important, but it is not the same as the market risk of an investment.

 

Investors with a long time horizon have no reason to consider what you've labeled as market risk. Volatility means that an identifiably wonderful company worth X, will sometimes sell for 2X, sometimes X, and sometimes .5X. And if you can just figure out what X is, you're going to get very rich over time. Market volatility is the friend of the intelligent investor.

[Palantir]

You may choose to ignore market risk because of your "very long time horizon", but that doesn't mean the particular property does not exist.

[JBird]

Yes. And similarly, you may choose to consider market risk, but that doesn't mean it exists.

;)

 

[racemize]

I spent a long while thinking about this question (particularly after reading all of Howard Marks' essays). I copied his format and wrote my own essay on it. Here is a link, if you are interested.

 

https://www.dropbox.com/s/5b536u4uqvxnr1v/2012-04-02%20-Stevens%20Fund%20Essay%20-%20Know%20Your%20Graph.pdf

 

Later I read Fooled by Randomness, which covers all these concepts pretty well on its own, so people may not find this essay all that insightful.  In any event, this is the way I think about/define risk.

[woltac]

I'm pretty sure risk IS volatility.

 

There aren't many people who don't like upside volatility. 

 

 

Not true. Take an asset that has only upside volatility, and compare it to an asset with equal expected return and no deviation in return (essentially a risk free asset with same E® ). You would prefer the volatile asset? I would not. On the other hand, if by upside volatility you mean volatility above the mean, then the asset would have a higher E®...above the RF asset...

 

Upside volatility is not separable from Risk, and not a meaningful concept, if I understand you correctly, you're looking at the positive side of the distribution and saying "This part is good", but the "good" side also comes with a "bad" side that WILL balance it out to equal E®. You have a dispersion of outcomes, and to an asset holder, given the same expected return, you want the asset with a smaller dispersion...

 

I hope understanding this concept is not a requirement for successful investing.

[JBird]

"The riskiness of an investment is not measured by beta but rather by the probability - the reasoned probability - of that investment causing its owner a loss in purchasing-power over his contemplated holding period." WEB, Berkshire letter 2011

 

"Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we're trying to do. It's imperfect, but that's what its all about." WEB, Berkshire AGM

 

"Munger did enormous trades like British Columbia Power, which wad selling for around $19 and being taken over by the Canadian Government at a little more than $22. Munger put not just his whole partnership, but all the money he had, and all that he could borrow into the arbitrage on this single stock- but only because there was almost no chance this deal would fall apart. When the transaction went through, the deal paid off handsomely." - The Snowball

 

"While still working this approach, Buffett had had what he would later call a "high-probability insight" about American Express that confounded Ben Graham's core idea." - The Snowball

[SharperDingaan]

You should be looking at the Sharpe ratio  ;) ...  & aim for around 1.75-2.00 

http://www.investopedia.com/terms/s/sharperatio.asp

http://www.investopedia.com/articles/07/sharpe_ratio.asp

 

The ratio is sensitive to measurement period; calculating quarterly produces a different result than if done annually. Seasonal hedging tends to drive up the ratio, adding a new position in quantity (concentrated portfolio) reduces it. As results are based on actuals, your best results are in down markets, & because you successfully hedged.

 

SD

[JBird]

Buffett has said over and over that the attractiveness of an investment is based on its after-tax return as measured by mathematical expectation (1966 Partnership Letter, 1988 Berkshire Letter), or said another way, by its probability-weighted range of values (2011 Berkshire Letter).

 

If the risk of an investment is based on the reasoned probability of a loss in purchasing power over the holding period, measuring the amount of risk taken in a single investment is straightforward.

 

Measuring the amount of risk taken in the entire portfolio is also simple. Take the probability of loss for each individual holding and multiply those probabilities together.

 

To use the coin tossing example where the value of Heads is -1 and Tails 1, the probability of loss in one trial is 50%. Two trials is 25%. Ten trials is 0.09%.

 

An expected value (EV) calculation forces the investor to assign probability weightings to his range of estimates of intrinsic value. Over time the investor can use actual outcomes to judge his effectiveness at weighing probabilities. In my view, the benefit of a EV estimate is clear; it's a tool the investor uses to not only help him looking forward, but to judge himself looking backward.

 

We're all terrible with precision when it comes to the future so we'll never get a probability-weighted range of values totally correct. I think it that in certain cases these EV numbers will prove useful though. A brief example to illustrate:

 

An investor allocates 100% of his portfolio in 15 stocks (with same value outcomes as the coin flip example). He estimates the probability of loss on any 1 of the 15 stocks is 50%. Now say the portfolio does lose purchasing power- the probability of him being correct about the odds and simply being a victim of bad luck is 1 in 33,333. (50% ^ 15)

 

Feedback appreciated

[Palantir]

So just because Buffett said "risk is chance of losing purchasing power" that means it's automatically right? :)  Btw....how would you define purchasing power? Purchasing power is a function of market price....but isn't price supposed to be different from value?

 

Risk of losing purchasing power is real, but that is not the only risk that is important to investors. You as a long term investor may be risk-neutral vis a vis price risk or volatility, but it is relevant in other contexts...

 

Personally, I think of Risk as the firm's operating results not meeting expectations. AKA, FCF doesn't grow as expected, margins contract, competitive position declines...however, if you're doing TAA, obv you would not look at that.

[Packer16]

I see risk comes from 2 sources in any assets.  There is fundamental/business risk which is intrinsic to the business.  This is what most investors think about when you say risk.  It includes the uncertainty of future cash flows or asset values and everything that causes that uncertainty.  The second (probably more important but less recognized) is price/value risk.  It comes from what price the market puts on an asset, is extrinsic to the asset and is based upon the facts and emotions. 

 

Value investors typically focus on the second source of risk and minimize it by paying a discount to value for assets.  Most people try to minimize both sources of risk.  This leads to "crowded" trades in low uncertainty value names from value investors.  This can work well when there is a panic but that is not most of the time.  But if you decide to minimize pricing/value risk but maximize uncertainty risk, then you get some interesting assets.  This is what Mohnish Pabrai calls "low risk/high uncertainty" situations.

 

Packer     

[SharperDingaan]

JBird you may want to revisit the Shape Ratio.

 

The purpose of using EV is to systematically increase your portfolio return through active management. As you could have simply put your $ into a T-Bill, the benefit of your management is whatever you make above the T-Bill rate. Probabilities are estimates, not actuals; the difference between the portfolio actuals & estimates is expressed as the portfolios standard deviation of return.

 

If too many of your choices are poor; over a 12 month period your portfolio return will we be lower than what you could have made if you simply put your money into a T-Bill. By actively managing, you have become in effect, your own worst enemy.

 

If you are better at diversification than you are at probability estimation; you may actually benefit from active management, but your portfolio standard deviation will be high - & your Shape Ratio will be low. As you get better at estimation your Sharpe Ratio will rise.

 

The more data points you take within the 12 month period, the more accurate your calculation will be. A PM will have infrastructure that calculates return and standard deviation each day, a retail investor might calculate once a month – if at all.

 

SD

 

[Phaceliacapital]

I see risk comes from 2 sources in any assets.  There is fundamental/business risk which is intrinsic to the business.  This is what most investors think about when you say risk.  It includes the uncertainty of future cash flows or asset values and everything that causes that uncertainty.  The second (probably more important but less recognized) is price/value risk.  It comes from what price the market puts on an asset, is extrinsic to the asset and is based upon the facts and emotions. 

 

Value investors typically focus on the second source of risk and minimize it by paying a discount to value for assets.  Most people try to minimize both sources of risk.  This leads to "crowded" trades in low uncertainty value names from value investors.  This can work well when there is a panic but that is not most of the time.  But if you decide to minimize pricing/value risk but maximize uncertainty risk, then you get some interesting assets.  This is what Mohnish Pabrai calls "low risk/high uncertainty" situations.

 

Packer   

 

+1