Understanding Risk!
Risk is something that we will always have with us as investors so it's best to accept this fact and then learn ways of dealing with risk. And since there really are just two kinds of risk, foolish risk and intelligent risk, this task is by no means all that difficult!
Let me pose this question: Suppose you could choose between two investments. One offers $1 outright, the other offers $1 per spot on the roll of the die. Which investment is riskier?
According to traditional risk measures which examine variability, the roll of the die is riskier -- your return could vary anywhere from $1 for one spot to $6 for six spots. But you would probably not think of it as riskier because it has no chance of underperforming the sure thing. In other words, the worst you could possibly do with the roll of the die is to receive $1 -- the same return that you would receive with the sure thing -- and the probability is large that you will receive more than $1.
Risk, or uncertainty, can be viewed in a variety of ways. If it is defined in absolute dollar returns, the first investment -- the $1 outright -- is certain, since the return will always be $1. However, if uncertainty is defined in relative terms, the roll of the die presents the certain alternative, because it is certain that the outcome will always be equal to or greater than the first investment.
Now, suppose we change the investment alternatives to a sure $3 versus $1 per spot on the roll of a pair of dice. The roll of the dice produces a less certain absolute dollar return than the sure thing, ranging from $2 for snake eyes (a pair of singles), to $12 for box cars (a pair of sixes). But many investors would hesitate to call it riskier, because there is only about a 3% chance that the roll would produce a pair of spots, generating a $2 return, and thus underperform the sure $3 return.
This concept also exists in the investment world. Is a portfolio that contains an equal amount of stocks and long-term bonds riskier than a portfolio that simply contains Treasury bills, which are commonly thought of as "riskless" investments?
The answer depends upon the length of your investment horizon. The stock market is very variable, but over the long-term the returns have been positive and much higher than those of Treasury bills. If your investment horizon is sufficiently long, the relative riskiness of a balanced portfolio is akin to that present in the dice example. The absolute dollar return on the balanced portfolio of stocks and bonds is less certain than the absolute dollar return on the Treasury bill portfolio. But it would be difficult to call the balanced portfolio riskier, because it is almost certain over a long-term period to provide a return that is higher than the Treasury bill portfolio.
This concept can be illustrated by looking at simulations of returns based on the historical performance of portfolios that include a variety of securities such as Treasury bills and bonds, corporate bonds, common stocks, and combinations of these securities.
When the probabilities of returns are compared, an important risk-reduction feature is evident: The probability of receiving a return that is less than that of Treasury bills decreases markedly as the investment horizon increases. Thus, the relative riskiness of an investment depends on the length of the investment horizon. It is also clear from this probability study that the portfolios traditionally viewed as more "risky" because of their volatility over short-term periods -- the stock portfolios and the stock-bond-T-bill combinations -- are less risky on a relative basis over long-term periods than the bond portfolios.
The probability of realizing returns below that of an all-Treasury bill portfolio decreases for a given portfolio as the investment horizon is lengthened. The most dramatic decreases are realized in the stock and diversified portfolios.
These results point to a number of important investment implications:
* The risk of a portfolio depends upon the length of the investor's planned investment time horizon. A portfolio may be highly risky if the investment horizon is short, but of modest risk if the investment horizon is long. And there are substantial benefits to diversification across time.
* The percentage of a portfolio invested in non-short-term debt should, everything else being the same, increase with the length of the investment horizon. In other words, the longer the time horizon, the more that should be invested in alternatives other than money market funds, since they will lower an investor's relative risk.
* The probability of underperforming some target return or target value is a measure of relative risk. This downside measure complements the traditional risk measures because it helps distinguish between uncertainty of dollar return and risk. The concept of relative risk also complements the traditional risk measures by highlighting important elements of the elusive concept of risk.
* * * * *
Let me pose this question: Suppose you could choose between two investments. One offers $1 outright, the other offers $1 per spot on the roll of the die. Which investment is riskier?
According to traditional risk measures which examine variability, the roll of the die is riskier -- your return could vary anywhere from $1 for one spot to $6 for six spots. But you would probably not think of it as riskier because it has no chance of underperforming the sure thing. In other words, the worst you could possibly do with the roll of the die is to receive $1 -- the same return that you would receive with the sure thing -- and the probability is large that you will receive more than $1.
Risk, or uncertainty, can be viewed in a variety of ways. If it is defined in absolute dollar returns, the first investment -- the $1 outright -- is certain, since the return will always be $1. However, if uncertainty is defined in relative terms, the roll of the die presents the certain alternative, because it is certain that the outcome will always be equal to or greater than the first investment.
Now, suppose we change the investment alternatives to a sure $3 versus $1 per spot on the roll of a pair of dice. The roll of the dice produces a less certain absolute dollar return than the sure thing, ranging from $2 for snake eyes (a pair of singles), to $12 for box cars (a pair of sixes). But many investors would hesitate to call it riskier, because there is only about a 3% chance that the roll would produce a pair of spots, generating a $2 return, and thus underperform the sure $3 return.
This concept also exists in the investment world. Is a portfolio that contains an equal amount of stocks and long-term bonds riskier than a portfolio that simply contains Treasury bills, which are commonly thought of as "riskless" investments?
The answer depends upon the length of your investment horizon. The stock market is very variable, but over the long-term the returns have been positive and much higher than those of Treasury bills. If your investment horizon is sufficiently long, the relative riskiness of a balanced portfolio is akin to that present in the dice example. The absolute dollar return on the balanced portfolio of stocks and bonds is less certain than the absolute dollar return on the Treasury bill portfolio. But it would be difficult to call the balanced portfolio riskier, because it is almost certain over a long-term period to provide a return that is higher than the Treasury bill portfolio.
This concept can be illustrated by looking at simulations of returns based on the historical performance of portfolios that include a variety of securities such as Treasury bills and bonds, corporate bonds, common stocks, and combinations of these securities.
When the probabilities of returns are compared, an important risk-reduction feature is evident: The probability of receiving a return that is less than that of Treasury bills decreases markedly as the investment horizon increases. Thus, the relative riskiness of an investment depends on the length of the investment horizon. It is also clear from this probability study that the portfolios traditionally viewed as more "risky" because of their volatility over short-term periods -- the stock portfolios and the stock-bond-T-bill combinations -- are less risky on a relative basis over long-term periods than the bond portfolios.
The probability of realizing returns below that of an all-Treasury bill portfolio decreases for a given portfolio as the investment horizon is lengthened. The most dramatic decreases are realized in the stock and diversified portfolios.
These results point to a number of important investment implications:
* The risk of a portfolio depends upon the length of the investor's planned investment time horizon. A portfolio may be highly risky if the investment horizon is short, but of modest risk if the investment horizon is long. And there are substantial benefits to diversification across time.
* The percentage of a portfolio invested in non-short-term debt should, everything else being the same, increase with the length of the investment horizon. In other words, the longer the time horizon, the more that should be invested in alternatives other than money market funds, since they will lower an investor's relative risk.
* The probability of underperforming some target return or target value is a measure of relative risk. This downside measure complements the traditional risk measures because it helps distinguish between uncertainty of dollar return and risk. The concept of relative risk also complements the traditional risk measures by highlighting important elements of the elusive concept of risk.
* * * * *
posted by Bob Moser at
4:28 PM
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