Modern
Portfolio Theory Risk Management* Actual investment risks and the probabilities of investing success are the risks and the probabilities directly and solely related to whether or not an investment advisor knows what he or she is doing and the level of judgment and the degree of skills he or she has in applying that knowledge to investing. Investment risks and investing probabilities cannot be predicted and managed by the standard deviations of historical investment data; their only practical value being to help explain, excuse, and justify errors; it's not my fault, Beta did this to us. |
| Where you are trying to go — Investment Planning: Investor's CalcStation | How you are going to get there — Portfolio Management: Investor's WorkStation | How well you have done — Modified Dietz Performance Calculator: PerfCalc | What you need to think about, know, do, have, use, forget, and avoid — Investing Principles and Perspectives: In My Opinion | Home | Contact Us | Free 30-Day Software Trials | Prices/Order Risk, as it is related to investing, is the measure of the potential for loss of capital and evaluating the amount of capital that may be lost. Risk management is the investment discipline of creating efficient investment portfolios; portfolios that create the best opportunity for gain with the least amount of risk of loss of investment capital. The measurement of investment risk is central to the issue of risk management. The standard of value for the measurement of investment risk should be what information and what action will have the most impact on investment risk? The current, most popular risk measurement tools are Standard Deviation, Efficient Frontier, Beta, VaR, and Sharpe Ratio. The universal
assumption of these risk measurement tools is that investment history is the investment
future; that investment history will repeat itself almost as reliably, as repeatedly,
as regularly, as frequently, and as predictably as the rain fall in the rain forests
of Brazil. Standard Deviation is variously defined as the measure of the amount of variation in any group of numbers that make up an average, the variance around a mean, or the quantification of the variance of returns. A normal distribution of data means that most of the examples in a set of data are close to the "average," while relatively few examples tend to one extreme or the other. If you looked at normally distributed data on a graph, it would look something like the illustrated "bell shaped" curve. By definition, one standard deviation away from the mean in either direction on the horizontal axis (the red area on the graph below) accounts for somewhere around 68 percent of, for example, investment returns. Two standard deviations away from the mean (the red and green areas) account for roughly 95 percent of investment returns. And three standard deviations (the red, green and blue areas) account for about 99 percent of investment returns. If
this curve were flatter and more spread out, the standard deviation would have
to be larger in order to account for 68 A sample of bonds typically has a small standard deviation because most of the returns are close to the average. Gold investments typically have a high standard deviation because there usually is a wide range of investment returns for each investment that makes up the average. However, just because there may be a wide range of investment returns does not mean that a class of investments has more risk than another class of investments which has a narrow range of investment returns. The standard deviation for bonds versus gold investments could change in an instant due to changes in economic conditions with gold investments having a low standard deviation and bonds having a high standard deviation. When gold investments seemed to be fundamentally and strategically valuable years ago, investors started buying gold investments and, as a result, individual investment returns became more similar in a buying frenzy that caused a general and almost equal price appreciation resulting in individual returns being closer to the average returns creating a low standard deviation and the appearance of low investment risk. The results were that the level of investment comfort and the probability of investment outcomes were artificially created. Bond and utility investment returns (perceived as low risk/low standard deviation investments) can easily have a high risk of performing poorly, gold (perceived as a high risk/high standard deviation investments) can perform very well and both can collapse at the same time though the first typically has a lower standard deviation than the latter. Sudden increases in interest rates will affect different bond valuations and returns in many different ways depending on the type, quality, and maturity of the bonds held, thus creating a high standard deviation; however, there could be a low investment risk because of the bond investment strategy being used in a specific bond investment environment. The worst case can be to conclude that, because a standard deviation is low, no action need be taken as valuations begin to fall. As a risk management tool, standard deviation is nothing more than a numerical way to record and retrieve investment history. Yesterday's standard deviation is not today's or tomorrow's standard deviation. Therefore, yesterday's investment risk as defined by standard deviation is not today's or tomorrow's investment risk. Standard deviation gives no insight into the actual investment performance determinant variables and, for this reason, is little more than comfort food for those who do not understand real investment risk and who are looking for information to justify their investment decisions, "But, the standard deviation was low when I bought this class of investments!" Standard deviation has little more than investing entertainment value for a quarterly review with a client or at a cocktail party; "We are on the efficient frontier with classes of investments that have low standard deviations and investments that have a low betas and high alphas, what could we possibly have to worry about?". The actual amount of investment risk will depend on the investment strategy used, what is bought, how much is bought, when it is bought, and for how long it is held. Effective investment risk measurement and investment management must focus on the elements that cause and effect actual investment risks and returns; investment judgment and investing by actual variable connections rather than by perceived variable coincidences:
|
percent of the investment returns. That's why the standard deviation can tell
you how spread out the examples in a set are from the mean.