Talk:Risk and return: an introduction

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Revision as of 11:54, 30 July 2019 by Longinvest (talk | contribs) (→‎Criticism: The need for a separate "Risk" page.)
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Plans for Sections

Currently working on improving the Intro and the first section. Will replace current chart with charts showing frequency distribution of returns for Bills, Bonds and Stocks, and will add text to further explain the relationship between risk, dispersion of returns, and expected returns.

Here is a list of sections I'm planning on adding. This is tentative; feel free to contribute ideas on sections to add:

  • Measuring Risk (variance, standard deviation, other)
  • Systemic and Unsystemic Risk (company-specific vs. market; theoretical justification for using mutual funds)
  • Managing Risk (asset allocation)
  • Risk Tolerance (age in bonds (Bogle), ability, willingness and need (Swedroe)
  • Risk vs. Uncertainty (Knight, Bogle, Swedroe))
  • Long-Term Risk (stocks are risky in long run: BKM, Bodie, Bogle?, Bernstein)

--Kevin M 14:22, 29 March 2012 (CDT)

Consider the relative level of difficulty for new investors. I don't think they want to see a full treatise on risk theory when all they need to know is that stocks have a better chance of losing money than other investments. This page should be aligned with Behavioral pitfalls (previously Risk, Uncertainty, and Behavioral Pitfalls) --LadyGeek 15:53, 29 March 2012 (CDT)

Agreed that it should not get too complex. Don't agree with the second statement. I spend a lot of time helping novice investors, not just on the forum, and there's a lot more they need to know about risk than that stocks can lose more money than bonds (stocks aren't the only investments that can lose a lot of money). Also disagree about alignment with the other risk article. There are two many articles with the word "risk" in them, and none of them do a decent job of covering the topic adequately, for novice investors or anyone else, IMO. I can either try to fix that here, or in yet another risk article, or if no one else sees the value in it, not at all (don't mean to sound defensive; it's just taking so much time and energy explaining what I'm trying to do that I can't actually make any progress on doing it). It's turning out to not be so easy to "be bold". --Kevin M 18:25, 29 March 2012 (CDT)

OK, I see your perspective and understand your approach. There's no need to spend any more time explaining. I'll help with formatting and minor corrections, if needed. --LadyGeek 19:50, 29 March 2012 (CDT)

Papers

Here, we can include links to papers which may be candidates for suitable references or as candidates for further reading.

Criticism

1) The current page only presents one specific definition of risk that is mostly centered on "risk" as "volatility".

But, risk can also be defined as the "possibility of loss".

An interesting definition for "risk" is that of Zvi Bodie who writes:

A few proposed definitions of risk that commonly surface include: the unknown; the chance that something harmful may happen; uncertain outcomes that may cause loss; and uncertainty that arouses fear.

Let’s discard the idea that risk is nothing but the unknown, because risk is more than the ordinary uncertainty that surrounds our lives. By referring to harm, loss, and fear, the next three suggestions reflect one fundamental property of risk: Somebody has to care about the consequences if uncertainty is to be understood as risk.

The notion of “caring” or “mattering” is central. It captures both the potential (objective) impact of uncertainty as well as its (subjective) bite. This brings us close to the definition we’ll adopt: Investment risk is uncertainty that matters. There are two prongs to this definition—the uncertainty, and what matters about it—and both are significant.

So, beyond the odds of hitting a rough patch, there are the consequences of loss to consider.[1]

2) The presented definition of risk makes the same mistake as rookie investors: it only considers the risk of assets and ignores investor-related risks. In other words, it assumes that the investor's financial plan is fixed and won't unexpectedly change. Risk should include such concepts as "change of plans risk".

3) The idea of using "expected returns" to define "risk" can be debated. It would be best to clearly identify that there are at least two schools of thought, about risk: a "loss that matter avoidance" school, and an "expected return"-based school.

I haven't seen any mathematical proof that somebody actually knows what the effective "expected returns" of broad markets are. What I've seen is various conflictual estimates of "expected returns" (sometimes accompanied with an error range) by various people and firms. There's no agreement on these estimates. This shouldn't be surprising because, (1) the word "expected" is used with its economics/probabilistic/statistical meaning, instead of the meaning (of actually expecting something) generally used by normal people (e.g. non-economists) and (2) the idiom "expected returns" hides the fact that it's no more than an "intelligent guess using metrics derived from empirical analyses of historical return data". --longinvest 16:58, 29 July 2019 (UTC)

This page is intended as an introductory tutorial, details are kept simple and at a high level. This is followed by Risk and return: application which shows how the concepts apply. The third page, Risk and return, goes into the details you've described. Interested readers can follow the pages from the Risk template at the bottom of the page.

--LadyGeek 01:08, 30 July 2019 (UTC)

I'll try to be clearer.

In its definition of "risk", the Securities and Exchange Commission (SEC) clearly mentions the two main views about it "uncertainty" and "potential financial loss":

All investments involve some degree of risk. In finance, risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks.

Every saving and investment product has different risks and returns. Differences include: how readily investors can get their money when they need it, how fast their money will grow, and how safe their money will be.[2]

This definition is very clear and doesn't involve any complex mathematical framework based on economic theory. While not explicit in the text, it is solely based on logic (Law of Supply and Demand) and arithmetic without any need to believe in the efficient markets hypothesis (EMH), the capital asset pricing model (CAPM), or any other economic theory.

The current wiki page on Risk (as of July 30, 2019) is very well written, but it only presents an economic-based view. My criticism is that, before presenting this complex view which ends up defining risk mostly as uncertainty/volatility, it's important to present (1) a SEC-like definition that includes both the "uncertainty / volatility" view and the "possibility of loss" view, and (2) to discuss the principle that risk is also affected by the investor's own circumstances which could unexpectedly change.

I also dislike the idea of starting by scaring the reader from the start by claiming that "Risk and return is a complex topic". I personally believe that the SEC has succeeded in its succinct definition to actually make it quite simple to understand. That's how things should be taught, by making them as simple as possible for learners.

Here's another example of an alternative presentation of risk. It's a list of 18 risks for retirees (along with mitigating solutions) that doesn't involve complex charts and mathematical formulas: Retirement Risk Solutions[3]. It includes investor-related risks such as longevity risk, health expense risk, frailty risk, and loss of spouse risk.

One last point. The concept of "expected return" is extremely complex, and involves a "guess". Here's how forum member lack_ey explained the process of trying to determine "expected returns":

We're dealing with stochastic processes with statistical characteristics that probably change over time. As you say, we are looking to the future, not the past. We are talking about what we think future distributions will more likely be. Expressing a view on what we think (future) expected value will be does not require crunching future data, as stated above. It is a guess, a prediction.

It probably will in part be informed by historical data, among other factors. Some people believe that the best estimate of future values is realistically determined by taking the mean of the past data. (This is better and more the case the better the historical mean reflects the actual expected value of the underlying distribution, and the more the future looks like the past.) The ones talking valuations, dividend yields, and other metrics are not in this camp—they believe some other information can improve the estimate over just taking the historical mean, that markets change and furthermore some statistics capture some of the changes at some level better than pure chance.

It's important to note that the actual expected value is unknown, even in hindsight. Because of the randomness, the observed outcomes may be biased relative to the underlying distributions. We never know if a certain past return of 8% happened because for example the expected value was 6% and we got lucky, or the expected value was 10% and we happened to get unlucky, or anything else. Furthermore, many think that the distributions are likely changing over time (were the distribution stationary, we would assume over the long run that we are not getting consistently lucky or consistently unlucky, and thus come into superior estimates as time goes on over what the statistical properties are, with more data). This all implies a very high level of uncertainty in all these forecasts, making static portfolio allocations a very defensible choice.[4]

Note how, in its definition, the SEC did not use the possibly-controversial term "expected return" and, instead, used a non-controversial formulation, writing: "In general, as investment risks rise, investors seek higher returns to compensate themselves for taking such risks."

In summary, I maintain my criticism. It can be summarized in three points:

  1. Risk has two fundamentally distinct definitions: (a) uncertainty / volatility, and (b) potential financial loss. The current article is unbalanced because it only presents (a).
  2. In the context of Bogleheads community members designing portfolios, risks aren't limited to investment asset risks; they also include investor risks. Taking both asset-related and investor-related risks into account, when designing a portfolio, is critical. It is important for the introductory page on risk to mention both types of risks.
  3. The high-level definition of risk presented to beginners shouldn't involve such a complex concept as "expected returns". It's OK to use the concept within later sections of the page, but not in the initial definition (e.g. not in the top section of the page).

--longinvest 13:19, 30 July 2019 (UTC)

I just realized, now, that by by asking for the "Risk" page, I actually ended up on the "Risk and return: an introduction" page.

This is probably the source of the problem, here. I think that a separate "Risk" page should be created. It could define risk and provide a link to this page for further exploration of the relation between risk and return.

--longinvest 15:54, 30 July 2019 (UTC)

References

  1. Risk Less and Prosper, Zvi Bodie and Rachelle Taqqu, 2012.
  2. What Is Risk?, U.S. Securities and Exchange Commision.
  3. Retirement Risk Solutions, David Littell (RICP Program Director), The American College.
  4. Bogleheads® forum post: Re: The Futility of Predicting Future Returns.