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Thursday, February 3, 2011

What is risk and why should you care? (published in May of 2010 in the SB News Press)

We often hear the word “risk” thrown around in many different contexts; from trying to cross State Street, to catching the latest computer virus (or real virus), to real estate and financial markets.  In this week’s column, and especially given the recent volatility in the financial markets, I will discuss risk, explain why risk is relative, and why local investors need to understand that risk is a moving target before they make investment decisions.

First, let’s define risk.  While at first it may seem strange that I would state that we need a definition, the reality is that risk can be defined a number of different ways.  Most financial market calculations of risk that so many financial advisors so freely quote (usually with no idea what the numbers really mean) are a measure of volatility for the specific market on which the risk measure is calculated.  For example, a specific stock may have a Beta of 2.  What is Beta, you may ask?  Beta is a measure of a security, or portfolio, against an Index.  It is the “against an Index” part that makes this risk measure relative—it is relative to the index. 

This brings up a great point (and my entire point of writing this), which is that risk must be compared against something for it to have any meaning.  If the stock in our example has a Beta of 2 as compared with the S&P 500 Index, we can now understand what this risk measure means (relative to the S&P 500).  A Beta of 2 means that this stock is twice as volatile as the S&P 500 Index, which is always assumed to have a Beta of 1.  Now we can put our example stock into perspective, so that we can better understand what its risk really is in relation to the index and also in relation to what we are comfortable with.

So, this explanation seems simple enough—we have a stock with a Beta of 2, which means it is twice as volatile as the overall stock market (S&P 500).  Unfortunately, nothing is ever that simple, especially when we are talking about investing.  Here is what you need to know: First, risk measures are calculated using data points.  Typically we use returns over a period of time and mathematically compare those returns to the returns of the index to get the risk measure (Beta in our example).  The tricky part is that stocks trade all the time, so returns are constantly changing; which means that risk parameters are constantly changing.  So, if we added a certain stock to our portfolio a year ago, based on its risk at that time, things could have changed dramatically since then, and therefore the risk in our portfolio could have changed dramatically too.

Also, keep in mind that the risk of the overall market is not static either.  In last week’s column, I wrote about how volatility has spiked recently in the wake of the European problems, and that premiums on options have jumped as a result.  That increase in volatility impacts everything that trades, including, of course, all stocks and the overall stock market (as well as the commodities and fixed income markets).  So, if our same example stock still has a Beta of 2 today, its relationship with the S&P 500 may still be the same, but its real (absolute) risk is likely dramatically higher today, even though compared to the S&P 500 it appears no riskier. 

Another aspect of the typical risk measures that advisors, mutual funds, pundits, etc, quote, is that they are based on total volatility, not the risk of losing money.  This means that half of the risk value calculated for a given investment for most risk parameters deals with the “risk” that the investment will go up.  This is because they are mathematical calculations of volatility—movement (up or down) of the returns of the investment over some period of time. 

I don’t know about you, but I am not nearly as concerned about volatility on the upside if I am long an investment.  We usually want all of the upside volatility we can get because that means our investment is moving up.  The point of this is more a matter of communication than anything else—investors see risk as the chance of losing money, while the financial services industry defines risk as volatility—the fluctuation of returns, up and down, over time.  It is hard to have a conversation when the two parties are speaking different languages!

Another interesting and important aspect of risk is that it impacts the valuation of markets.  A better way to state this is that the perception of risk causes investors to react (buy or sell).  If a certain market, like Greece for example, is perceived to have increased dramatically in terms of risk, investors will sell that market, just like they would sell a stock if the company has a dramatic change in its perceived risk.  Another way to understand this is to say that investors will demand a much higher risk premium to invest in a market like Greece, if they perceive that the risk has increased dramatically.  In other words, the investor will have to perceive that they have the potential for a much higher rate of return to entice them to invest in a riskier market.  The net result is the same, in that the value of the market would have to come down so that there is more potential to make profits, otherwise investors will not buy into that market.

 What normally happens when risk increases is that investors pull back and seek quality.  The effect of this is that riskier markets tend to go down more than less risky markets.   The implication is that those markets, such as foreign markets in Europe, Asia, and developing countries at at more risk of significant declines, as opposed to our markets.  For those investors using asset allocation recommendations from advisors who are not taking into account the changing relationships of risk among the various markets, (and instead are using assumed, historical long-term average risk parameters), your portfolio very likely contains a lot more risk than you want or realize.  This would be especially true if you have foreign investments.

When making any investment decisions, from your asset allocation down to individual security selections, risk must be a top consideration.  It is not enough to simply look at a Beta, Sharpe ratio, Treynor Ratio, or even some of the more sophisticated risk parameters that attempt to quantify only downside risk, on a static basis.  Rather, just as your asset allocation must be updated to reflect the current and expected future market and economic environments, your understanding of the real risk—the risk of losing money—must be updated regularly, and must reflect the current environment.  Given the extreme jump in market volatility, and especially in the volatility f foreign markets, that we have seen over the past few weeks, it is more important than ever to make the effort to understand risk and to make appropriate changes to portfolios.

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