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The relationship between investment risk and expected returns

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Risk is not really about volatility and market sensitivity – it is about ambiguity. Your quintessential risk/return graph fails to incorporate the uncertainty associated with riskier investments. Dodgier investments have higher expected returns and the potential for low returns/permanent losses. These facts keep an already tumultuous relationship between financial analysts and an unpredictable market continuously guessing.

There are many investment professionals who believe risk can be computed and statistically manipulated. They depend solely on measures like the ones listed below to evaluate risk. Although these measures can be useful, using quantitative metrics devoid of thoughtful decision making is sure to yield disappointing results. Let us briefly examine these measurements and the rationale for using them:

Standard deviation (volatility):

Standard deviation is a degree by which the dispersion of a fund’s returns over time will fluctuate in any given direction. A large (small) diffusion of returns tells us how much (little) the fund digresses. A larger standard deviation specifies that the returns will be more untrustworthy in the short term, and to some investors this unreliability poses too great a risk to make a move on.

Downside deviation:

One of the criticisms of standard deviation is that it embraces positive returns while investors are usually only worried about negative downslides. Downside deviation has all the characteristics of standard deviation except it only includes diffusion to the downsides.

Value at risk (VaR):

VaR is a reasonably new model, having been introduced to the investment realm in the late 1980s. Now, the mainstream population which comprises of institutional investors and hedge funds swear by the VaR variable, using it frequently in their risk management system. VaR is a worst-case scenario estimate of a portfolio’s loss potential. One could calculate daily, monthly, or annual VaR numbers.

Case in point: if a portfolio has a one-month 5% VaR of $18 million, this means that there is a 0.05 probability that the portfolio will decline more than $18 million within a month. Risk managers like VaR because it spits out a single statistical measure of the probability of loss, it is easy to interpret, can be quickly calculated, and can be used for all types of assets.

Permanent loss of capital

The prospective for perpetual loss of capital is the most noteworthy risk in investment nomenclature. How could it not be? Surely that is scarier than seeing the volatility of your stock rise from 10% to 15%. A permanent loss of capital will occur when:

  1. You take on excessive leverage and, one day, are forced to liquidate at distressed prices to meet a margin call.
  2. You grossly overindulge in an asset. The highest rate of capital destruction will inevitably occur when investors buy enterprises that were considered flawless, at prices that reflected that nothing could go wrong.
  3. The foundation of a business severely depreciates.
  4. Investors mix emotional investing with financial sensibility.

Consider the likelihood that you will see permanent loss in an investment and to what extent that may be. This is often difficult to do alone, and a trusted advisor can help.

It is clear that investment risk comes in many forms. Certain risks will matter to some investors but not to others. This leads us to the next question: Exactly how should one assess, measure, and think about risk?

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