Rational Advisor

‘The pain of loss is far more intense than the pleasure of gain” - unknown

Risk is one of those words which are easy to define but not so easy to understand. Simple financial risk is the chance of exposure to monetary loss. But understanding it, even without all the Greek mumbo-jumbo that academic finance programs teach, is anything but simple.

Too many times we are preached the standard deviation, the Sharpe ratio, the Sortino ratio etc etc, and we are meant to feel good that risk has been understood – just because they gave it a fancy name. Not so.

Just as some medieval astronomers went about looking at the movements of the Sun and planets to prove the then prevailing belief that the Earth was the centre of the universe, finance academics also attempted through their statistical telescopes to look at what investment managers and financial analysts actually do and attempted to fit the data into their theories. From these were born a whole generation of fundamental factor models, macroeconomic factors and statistical models. And so risk came to embrace just not volatility, but other factors such as the above mentioned, standard deviation (sounds more like something out of an X-Men movie – “You are two standard deviations away from being a normal person hence you are an X-Men”, Sharpe Ratio (this is how much pain you will get if you cut yourself with something sharp”) or the Sortino Ratio (Tony Soprano will send his goon Sortino after you, if you don’t watch what you are doing”) amongst a whole slew of others.

Amos Tversky, a famous psychologist, after a number of lab experiments concluded that in daily living people are more concerned about losses than gains when taking risks - whether of careers, marriages, Toronto Maple Leafs, Toronto FC, Toronto Raptors, Toronto Blue Jays (anything sports team with the word Toronto in it) or the stock market i.e. fear normally predominates - “people are much more sensitive to negative than to positive stimuli, There are a few things that would make you feel better, but the number of things that could make you fell worse is unbounded”.

Realize that when considering possibilities, risk taking has a negative bias, when confronting the unknown, the human psychology of risk taking focuses normally on what might be lost. And this is what needs to be understood, what “can” be lost.

Realize that risk has no memory, no history in which one event leads to and shapes next - inherent therefore in risk is regression to the mean. Which to me, is one of the most important concepts to understand when thinking about investing. Peter Bernstein in his “Against the Gods” wrote: “We pay excessive attention to low probability events accompanied by high drama and overlook events that happen in routine fashion… as a result, we forget about regression to the mean, and end up in trouble.”

Any assessment of risk and the way it is dealt with is highly personal. Furthermore it is also dependent on the knowledge of ignorance of certain facts. As warren Buffett remarked “Risk comes from not knowing what you are doing”.

So, even though Academia has brewed the potent concoction of risk factors that money managers use to justify their Risk management. The plain and basic truth is that Risk is the loss of monetary capital.

And it requires two things,
1) An understanding of your investments
2) A time frame for investing

If you do not have a proper understanding of the “potential” for loss of capital in your investment – you do not understand it

If you do not have an appropriate time frame for investing, than your “potential” for capital loss increases.

Fughedabout Standard Deviation, Sharpe, Sortino and their sister Risk-adjusted-return

Realize that in any investment there will be periods of negative returns, and these will happen about once every four to five years, and they will seem much longer than they really are. But Sound investments do return to normal – because of REGRESSION TO THE RISING MEAN, you just need to 1) understand what you own, and 2) have the right time frame.

Rational

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