Appreciating Risk

In contributing to Saturday's conversation, Jeff from Milan recycled quite the nugget from Nassim Nicholas Taleb: if people really understood the risks of investing in equities, they'd never do it.

While I do not agree with never investing in equities, it is very clear that people generally do not appreciate risk or perhaps more correctly - the effect that volatility has on their psyches. The words risk and volatility get interchanged often, but I don't think risk is the best word, especially for people who use funds (traditional or exchange traded). A fund is not reasonably speaking going to go to zero, so what you are vulnerable to in that instance is volatility.

Anyone who implemented a portfolio of funds in December 2007 became subject to some very painful volatility, and if they were not lucky enough to have taken some sort of defensive action, then they are way off their low-water mark. At some point they will get back to their high water mark, of course, but as I always say, the time needed could turn out to be "too long".

Risk would seem to be more like putting all your money into a restaurant that subsequently fails. Putting too much into any one stock could also be risky but done correctly, buying individual stocks doesn't have to be risky, as opposed to taking on the threat of volatility. A portfolio of 50 stocks, each weighted at 2%, faces very little risk but plenty of volatility. If the market cut in half after purchasing those 50 stocks, then clearly the volatility would be brutal, but the odds of even one stock failing (based on the number of stocks that go to zero versus the number of stocks that exist) are pretty low. Possible, yes, but the probability would be low.

The context of this conversation, of course, assumes correct asset allocation. You don't put a $50,000 college fund for an 11th grader into equities.

But after things have been good for a while, people forget how they felt when things were bad and they go on to repeat or come close to repeating the type of behavior that supports Taleb's assertion. I remember in 2006 getting a lot of email in my TSCM email account from people not understanding my belief in small weights to emerging markets. Then sure enough in the 2nd quarter of that year, there was a short but reasonably deep correction that rattled some people and one reader emailed back saying that they understood where I was coming from.

We know that after a bull phase there will be a bear phase. The bear phase will erase some portion of the gains made in the bull phase. If we can operate with this in mind and try to navigate toward a result thought of in the time frame of an entire bull-bear cycle, it should lead to a different take on how much volatility you expose yourself to. It also gets you away from gaming XYZ's earnings report or trying to figure out how to make money this week.

Comments

[Ricard:]

There is risk, and then there is volatility.

Volatility is your friend, your dearest friend, if you've done your homework.

Risk, on the other hand, is never your friend. It is the one thing that investors should systematically weed out of their portfolios.

Nov 01 12:43 PM

[Plant the s...:]

The only reason you get above treasury return on stocks is to compensate investors for risk in holding them. Investors do tend to overpay and risk is difficult to measure accurately.

Nov 02 11:33 AM

[Robert.from.Ct:]

Thank you,Please write more articles on asset allocation and risk...Not enough articles on these subjects

Nov 04 09:41 PM