Author Topic: Risk  (Read 2606 times)

scintilates

  • 5 O'Clock Shadow
  • *
  • Posts: 5
Risk
« on: July 06, 2015, 06:48:12 PM »
Hey forum - I've been reading through a lot of material here, and there's one question I keep coming back to.  It seems to me that there are (at least) two different kinds of risk which get conflated a lot.  I don't know the actual terminology for this, but let's call the two types "random" risk and "new normal" risk.

Random risk is what you get when you treat the market as a random walk or similar process - you can measure the standard deviation over a given time period, and that fluctuation gets labelled "risk".

New normal risk I'm naming after the oft-repeated saying during market crashes that "this time it's different", or "this is the new normal".  It means the market has fundamentally changed, and there is no longer an expectation that past performance will be a reasonable predictor of future risk.

Another way to put it would be to go back to the random walk model.  Random risk is just the standard deviation of the walk.  New normal risk takes that random walk and replaces it with a completely different one with different underlying parameters.

This is relevant to me, because I have very different aversion to these two different types of risk.  I'm early enough in my accumulation phase that random risk just doesn't matter much to me.  New normal risk though I still do care about - if the future ends up not looking anything like the past, that's a major concern.  However, we don't get to see the "underlying paremeters" for the stock market (because they don't exist), so it's difficult to tell what type of behavior you're currently seeing - is this time actually going to be different?  Who knows?

Are there more official terms for these, and is this a common distinction people make?  It seems like any possible deviation from "your investment will grow at exactly X% per year" gets lumped under the general heading of "risk", which I find irritating because it isn't obvious to me that the standard deviation of an investment is highly correlated with future returns not resembling past ones.

Thanks!

Financial.Velociraptor

  • Handlebar Stache
  • *****
  • Posts: 1500
  • Age: 47
  • Location: Houston TX
  • Devour your prey raptors!
    • Financial Velociraptor
Re: Risk
« Reply #1 on: July 06, 2015, 07:00:55 PM »
Your concepts wouldn't fly in a University finance class.  The two types of risk in Finance are usually defined as:

Systemic: This is big events such as super volcanos, major war, government default, widespread global recession/depression that can't be diversified away
Specific: This is the risk to XYZ company related to a lawsuit or strike, etc.  You build a diversified portfolio to take the sting out of this risk.

I had an old finance prof who was fond of saying "Daddy always said, 'you pays you monies; you takes you chances'".  I should probably  note that "Daddy" was also a PhD professor of finance from West Texas.  The lesson is, you can't eliminate risk, but you can do 'best' by having good diversification.  YMMV.

johnny847

  • Magnum Stache
  • ******
  • Posts: 3192
    • My Blog
Re: Risk
« Reply #2 on: July 06, 2015, 07:02:53 PM »
Hey forum - I've been reading through a lot of material here, and there's one question I keep coming back to.  It seems to me that there are (at least) two different kinds of risk which get conflated a lot.  I don't know the actual terminology for this, but let's call the two types "random" risk and "new normal" risk.

Random risk is what you get when you treat the market as a random walk or similar process - you can measure the standard deviation over a given time period, and that fluctuation gets labelled "risk".

New normal risk I'm naming after the oft-repeated saying during market crashes that "this time it's different", or "this is the new normal".  It means the market has fundamentally changed, and there is no longer an expectation that past performance will be a reasonable predictor of future risk.

Another way to put it would be to go back to the random walk model.  Random risk is just the standard deviation of the walk.  New normal risk takes that random walk and replaces it with a completely different one with different underlying parameters.

This is relevant to me, because I have very different aversion to these two different types of risk.  I'm early enough in my accumulation phase that random risk just doesn't matter much to me.  New normal risk though I still do care about - if the future ends up not looking anything like the past, that's a major concern.  However, we don't get to see the "underlying paremeters" for the stock market (because they don't exist), so it's difficult to tell what type of behavior you're currently seeing - is this time actually going to be different?  Who knows?

Are there more official terms for these, and is this a common distinction people make?  It seems like any possible deviation from "your investment will grow at exactly X% per year" gets lumped under the general heading of "risk", which I find irritating because it isn't obvious to me that the standard deviation of an investment is highly correlated with future returns not resembling past ones.

Thanks!

I always laugh at statements like these. Of course it's different. Since when is a stock market crash exactly like any previous stock market crash?

Addressing your overall concern - I would argue that we have had "new normals" throughout the history of the US stock market (and I'm sure every country has had them). The Federal Reserve was created in 1913. The Calyton Antitrust ACt was passed in 1914. The Great Depression certainly set a new normal - far more regulatory agencies and other government bodies came into place, such as the FDIC. The US came off the gold standard in 1933. Social Security came into effect in 1935. WWII brought us out of the Great Depression. After WWII the US became a superpower. In 1965 we amended the Social Security Act to create Medicare and Medicaid. In 1972 the Arab oil embargo started. There was the great deregulation of the late 70s/early 80s. In 1980 inflation hit 13.5 percent, leading to Congress passing a law which gave the Fed greater power over banking regulations (which I believe included the reserve requirement). In 1987 we had black Monday, the single largest 1 day stock market drop in US history - it was never even though possible before.  In the late 80s we had the savings and loans crisis. In 1994 we signed the North American Free Trade Agreement. We had 9/11. In 2007 the housing bubble burst, which subsequently lead to laws reforming that sector.

Most if not all of those things I just listed above are all what we consider as "new normals." We see this on a regular basis. I don't see any reason for concern because the US stock market has plowed through all of them.

YoungInvestor

  • Bristles
  • ***
  • Posts: 408
Re: Risk
« Reply #3 on: July 06, 2015, 07:16:06 PM »
Sure, the distinction exists.

Market risk is the risk related to the uncertainty of future prices of your assets.

Model risk is the risk related to having incorrectly modelled your investment assumptions (i.e. things become "different" as the model we use (mostly based on past returns) would be incorrect (growth (as a whole) stops as technology reaches a peak level or whatnot, etc.)). That term is usually used to refer to milder errors in models , but I think it's the most appropriate here.

Systemic risk is the possibility of an event that alters the nature of the system (catastrophic natural events, social system changes, etc.).

For more info I think wiki or Google will certainly have lots of info about the different types of financial risk.

scintilates

  • 5 O'Clock Shadow
  • *
  • Posts: 5
Re: Risk
« Reply #4 on: July 06, 2015, 07:22:42 PM »
Thanks for the replies.  Just to clarify, I'm not in a panic about "new normals", and Johnny I do agree that we have them all the time.  I'm mostly focused on US/world stock market here when I mention returns.

First things first, I am aware of systemic vs specific risk, and do agree that diversification is useful

Young, that is helpful - I hadn't heard the term "model risk" before, that should be helpful in my googling

Is it widely believed that these different kinds of risk are correlated?  It seems like most of these should behave completely differently, but apart from the specific risk vs systemic risk distinction I don't see a lot of lip service paid here to these as separate phenomena.

mr_orange

  • Walrus Stache
  • *******
  • Posts: 5612
  • Age: 40
  • Location: Round Rock, TX
Re: Risk
« Reply #5 on: July 06, 2015, 07:23:40 PM »
One of the posts above already covered the traditional finance class definition of risk.  Systemic risk, by definition, is NOT controllable and thus cannot be diversified away.  Most other risks with traditional finance instruments can be controlled by investing in a broad basket of securities that move somewhat independently during different market conditions.  The idea is to diversify away as much of the controllable risk as one can. 

However, I think your post deals more with the overall "past performance is not an indicator of future results" weasel language that folks in the financial industry like to append to marketing literature.  What if this time it is really different?  After all, we now have a global economy with information systems that didn't exist before.  We also have different regulatory regimes, laws, etc. as well.  How can one tell if any of this now applies?  Best of luck figuring that one out!

The biggest risk in life is not taking any.  Even "safe" investments like government bonds are subject to large risks like inflation risk. 

One of the main reasons I like investing in real estate or other small businesses is that I can control the investments a lot more than I can control anything a large company does.  With this control I can pick the risk/reward with the investment dollars with a lot better sense for what may happen in the future. 

For what it's worth this article by John T. Reed is worth reading about the nature of investment:

http://www.johntreed.com/investment.html

There is a lot of truth to the article.  Investing in many ways is not a whole lot different than gambling in slow motion.  Fortunately if you do it for long enough the mean reversion should yield pretty good results, but some periods of 20 years have delivered pretty sub-optimal returns.  Given that this is possible I still like being able to control my investments. 

Financial.Velociraptor

  • Handlebar Stache
  • *****
  • Posts: 1500
  • Age: 47
  • Location: Houston TX
  • Devour your prey raptors!
    • Financial Velociraptor
Re: Risk
« Reply #6 on: July 06, 2015, 07:24:34 PM »
Systemic risk isn't believed to be correlated to anything.
Specific risk is a weird bunny.  In theory the correlation equals the "beta".  In practice?!?

innerscorecard

  • Pencil Stache
  • ****
  • Posts: 589
    • Inner Scorecard - Where financial independence, value investing and life meet
Re: Risk
« Reply #7 on: July 07, 2015, 01:03:40 AM »
From the present, all the risks of the past look like "random walk" risks. The risks in the future look like that too, until they get to the present, where they suddenly look like "new normal" risks. That's why investing is hard. Everyone investor on here and other boards talks about how they would love to have a big drop in stock prices. But they don't understand that it would be accompanied by a change in conditions as well, that will surely make most people panic due to expectations of a long new normal.