Monday, October 15, 2007

What Is Risk?

A young woman recently told me she wants to learn more about "risk."

In discussing the term with her, I quickly realized that it is used so differently, in so many technical contexts, that she probably has no clear idea just how complex the topic has become.

In an attempt to return to some simpler expression of the term, I sought a definition. On Wikipedia, which is not usually one of my first choices, I found this information,

"Risk vs. uncertainty

In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the distinction between risk and uncertainty.

“... Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term "risk," as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. ... The essential fact is that "risk" means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. ... It will appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We ... accordingly restrict the term "uncertainty" to cases of the non-quantitative type." "

Since it's a quote attributed to Frank Knight, I felt it worthy of presentation here. And, additionally from Wikipedia,

"In finance, risk is the probability that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.

In finance, risk has no one definition, but some theorists, notably Ron Dembo, have defined quite general methods to assess risk as an expected after-the-fact level of regret. Such methods have been uniquely successful in limiting interest rate risk in financial markets. Financial markets are considered to be a proving ground for general methods of risk assessment."

As a general meaning, I think this is not far from the mark.

To me, risk is the probability, typically expressed via some variant of standard deviation, that actual returns or profits will be less than expected. It is an asymmetric concept, in my opinion.

To use symmetric measures, such as beta, or full, bi-directional standard deviations, is incorrect. Upside variance or deviation is good and, therefore, not 'risk' as we mean it here.

That said, my discussions with others has brought an agreement that the various technical meanings of risk tend to differ because of context.

For instance, I began to describe to the young woman in question, a college student, four different contexts in which one could measure risk: fixed income rating; loan underwriting for portfolio holding; equity investment management, and; institutional trading.

All four scenarios have risk which must be expressed quantitatively and managed.

Rating agencies like S&P, Moody's and Fitch want to minimize unexpected, quick downgrades of their prior ratings. Loan originators and portfolio lenders want to limit negative surprises which cause downgrades of their loans, and the loss of principal. Equity portfolio investors want to minimize the likelihood that a firm's future performance during the expected holding period will be worse than expected. The same is true for traders, although their timeframe is the shortest of the group.

Essentially, risk in its various contexts requires measurement of downside variance of actual from expected returns over different time horizons. Risks which a trader would not accept, may be, and often are, completely acceptable to me, as a longer-term equity portfolio manager.

For me, after choosing the appropriate time over which to calculate downside standard deviations of historic actual from expected returns, these may be used to adjust the actual returns. No matter what the context or duration of holding period, the concept of measurable downside variance, with which to adjust nominal returns, seems to be a valid and transferable approach to describing, measuring and managing risk.

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