Sunday 2 September 2007

Risk - volatilty or loss?

One term that differs slightly in everyday use from its specific meaning in relation to personal finances is "risk". In everyday parlance the expression "risk" is used to describe the chance of losing something of value - health, wealth, happiness and so on. However, this is slightly different from the meaning of the term risk when used to describe expected investment outcomes. The financial definition started out from the same point - the chance of losing one's money in making an investment - but this was then defined in mathematical terms relating to the chance of the actual investment return deviating from the expected outcome. This use of the term can produce some counterintuitive definitions of what investment or choice has the greater risk. For example, leading up to the '87 crash the market wasn't particularly volatile, but the crash involved some very large one day movements in the market index, which increased the value of market risk. This meant that, on paper, this asset class had higher risk after the crash, when prices were considerably lower.

Another good example of this confusion in the meaning of "risk" was described in Kevin Bailey's book "Your Money Guide". He provides the example of two people who skydive out of an airplane at great height. One is wearing a parachute, the other is not. Which one has the greater risk? The answer to this depends on your definition of risk.

Based upon the definition of risk as uncertainty of outcome the person with a parachute has a greater range of possible result - the 'chute may not ope, wind might cause landing in a tree or powerlines, or the landing could be safe. The person without a 'chute has less chance that the outcome will differ from what you may expect - a rapid plunge to a quick death. Hence in financial terms the parachutist is a speculator, and the person leaping out of the plane without a 'chute has greater "risk" in relation to the expected result.

Copyright Enough Wealth 2007


S. B. said...

There was a push a few years back to use semivariance instead of variance in risk models. However, if the distribution is not skewed much, it does not seem to add a whole lot to the conversation.

In the case of the man without the parachute, I suppose any variance calculation is always going to be viewed as about zero. Perhaps emphasizing the expected outcome in addition to the variance helps to clarify the situation.

Anonymous said...

My definition of risk includes the risk of not making money, not just the risk of losing money. By putting money in a CD you remove downside risk, but incur upside risk if the market performs better than the CD's rate of return.

Good post.

xXx said...
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