Tuesday, 9 October 2012

What is Investment Risk?

This may seem lie a rather incongruous name for a post given most of us know inherently know what investment risk is.  To most of us it is the risk that we lose money.  However you may be interested to know that this is not how finance theory thinks about risk.  Indeed statements such as 'diversification is good' is based on another definition of risk altogether.

As a little bit of background as to why I am bringing this up. I was recently re-reading a book on Warren Buffet, The Essential Buffet (which I have reviewed before), and I came across a section where the author talks about how Warren Buffet uses the 'common sense' approach to risk (as I have defined it above) rather than the finance theory approach to risk.

How does financial theory define risk?

Financial theory (and trusty Investopedia) defines risk as:
The chance that an investment's actual return will be different than expected.  Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.  A high standard deviation indicates a high degree of risk
The word 'different' in the first sentence is really the key word in the whole statement.  If a return is different from expected - even if it is higher - then this is a 'risk' in financial theory.  Financial theory defines risk as a deviation from what you expect and certainty is held paramount.

Now while you may be spotting the obvious flaw in the above definition let me say first that financial markets (and people generally) pay a high price for certainty.  The more certain your return is the lower that rate of return is.  This is why government bonds have the lowest return - they are the most certain.

What is the problem with this definition

When we are brought up - risk is generally viewed as a bad thing.  The objection that Warren Buffet has to the finance definition of risk is that is views upside risk in the same way it views downside risk which to him seems nonsensical.

If we dig a little deeper into the assumptions surrounding risk (and standard deviations and statistics more generally) we see one fact that the traditional risk assumptions make that does not necessarily hold true in the real world - it assumes a normal distribution.  For all of you reaching back to your high school maths don't worry about getting out your text book - this just means that the probability of something occurring is centred around your mean with an even distribution either side of this mean.

This inherent assumption means that the probability upside risk associated with an investment is equivalent to the downside risk.  In this scenario you can see why certainty may be better and why more risk is worse.

However as I indicated above - life and financial investments are rarely normally distributed.  What Warren Buffet is trying to say is that if you can find an investment with limited downside risk and significant upside risk - then this is less risky (in a common sense approach to risk) than financial theory would generally suggest.

Why is knowing this important (and why did I bother writing a whole post on it)

The finance definition of risk is central to modern financial theory and to the way that financial products are priced and traded.  If you recognise it's short comings you can benefit by investing to take advantage of upside risk.

If you understand this definition of risk you will also understand why people say that diversification is good (I'll do a post on this very soon), why academics claim that you cannot beat the market (contrary to what some investors achieve) and how to take advantage of this for your own benefit.

You May Also Be Interested In:
Too much financial news is a bad thing - it makes you miss the good ideas
What is TERP and how do you calculate it?
What is QE3 and why did the market react so strongly to it?
Investopedia is a great reference tool - but don't trust it completely

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