Three ways to "Risk"

"Risk" is a versatile, albeit somewhat ambiguous term in financial markets. Journalists like to say, "traders are paid to take risks," traders use risk often to mean a position in the markets, i.e. "I like this risk, so am leaving it on."

But really, what is risk

1) Volatility - the mainstream academic and practitioner's method.  Volatility can be standard deviation of returns in an absolute basis or relative to a benchmark. Have an equity portfolio that often swings 2x as much as the market on a daily basis? You are twice as risky as the market. Bond traders measure a bond position's "risk" by sensitivity to interest rates (e.g. treasury yields of matching tenor). If the bond position you have moves 10% if rates (treasury yields) move by 1% your duration is 10 and when converted into dollar terms (dv01, dollar value of a basis point), that's your risk.

Then for credit products/corporate products - what happens if the credit spread of your AA bond widens by one basis point? If your duration is 5, you lose 5bps of face/mkt value (depending on your specific definition of "duration" etc.). That's risk too.

The list continues, but idea is this - only a daily basis, how much could the market value of your investment change in value, either on absolute or relative to a benchmark? Or in other words, how much does the market herd affect your investment tomorrow?

2) Being "right", or permanent loss of capital. The value investor/distressed investor, used by many Michael Burry of Scion Capital, Howard Marks of Oaktree, and of course Warren Buffett of Berkshire Hathaway.

Who cares about the noisy of the crowd? What matters is when the investment matures (or over a long period), does the underlying investment make the money? I.e. for corporate bonds, will the issuer pay me back interest & principal?

Naturally, this is easier for fixed income than for equities (or is it?), since there is a built in catalyst (maturity). Nonetheless, if you buy FB on the belief that it will earn $10B a year in profits 3 years from now and are correct, the market price at that time will probably be higher. In other words, forget about tomorrow - how about many years from now?

3) Drawdowns - until your exit, how much can the market move against you? Disclosure: my personal favorite, though admittedly much harder to measure/reduce. Used by some fund managers such as Monroe Trout from New Market Wizards (portfolio wide stops of down x%, when he'd liquidate all).

If you want to buy FB in anticipation of that $10B net income (that your presumably researched etc), how much could the stock go down from now until then? Do you expect that eps growth will be linear, exponential, noisy? What if next quarter's eps misses? Based on the last miss, a 10%+ drop would be possible. But is that a reasonable comparison?

^Those questions are far harder to answer, but may be more fruitful? After planning your actions (if any) and adjusting the position size/composition, it might remove some of the emotions of a casino-like quality of investing.

Indeed, the final approach is, how much pain will there be until proven right or wrong?

What other thoughts on risk do you see?

 

Est eaque eligendi voluptatem. Quod ullam occaecati est molestiae ex explicabo. Dolores sed excepturi et deserunt ullam quia.

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