Step 8: Riskese

Riskese
Understand how risk, return and time are related


Riskese





8.1

Introduction

Do you speak riskese? Residents of China speak Chinese, citizens of Japan speak Japanese, lawyers speak legalese and top-notch investment advisors, casino statisticians, and insurance underwriters speak riskese. Riskese is the language that’s used to discuss topics of risk, return, time, and correlation.

Risk, return and time are all intertwined. Higher exposure to the right risk factors leads to higher expected returns. The longer you hold a risky investment, the more likely you will obtain the long-term expected return. However, because of “random drift,” risk is very unpredictable in the short run, but it can be quantified far more accurately than gut feelings and intuition in the long run. For example, you can flip 10 heads in a row with a coin, but there is still a 50/50 chance that you will flip heads the next time and in the long run. Remember that if there is no risk, there is no reason that you can expect a higher return than Treasury bills, which have paid an annualized return of 3.8% per year for the last 70 years, just 0.5% over inflation.

High risk exposure is like a scream inducing roller coaster, with soaring highs and stomach churning lows. On the roller coaster, the greater the ups and downs, the greater the returns... measured in thrills. The same thing applies to investing. However, not everyone has the “capacity” for such “exposure” to risk. In this step the concepts of risk, return and time will be explained.


Quotes


Charles Ellis " The average long-term experience in investing is never surprising, but the short-term experience is always surprising. We now know to focus not on rate of return, but on the informed management of risk. "
Charles Ellis, "Investment Policy," 1985 (a must read)
Nova Special " Since the dawn of capitalism, there has been one golden rule: "If you want to make money, you have to take risks. "
Opening line of the Nova Special, "The Trillion Dollar Bet"
William Bernstein " If your broker [or investment advisor] is not familiar with the concept of standard deviation of returns, get a new one. "
William Bernstein, "The Intelligent Asset Allocator"
Gary Belsky " Odds are you don't know what the odds are."
Gary Belsky and Thomas Gilovich, "Why Smart People Make Make Big Money Mistakes" (contributed by Munzer Haque)
Robert Arnott " In investing, what is comfortable is rarely profitable."
Robert Arnott, Investment Manager
Robert Heinlein "There ain't no such thing as a free lunch."
Robert Heinlein. This quote's acronym TANSTAAFL from "The Moon is a Harsh Mistress"
Nobel Laureate, Harry Markowitz "… the investor does or should consider expected return a desirable thing and variance of return an undesirable thing "
Harry Markowitz, "Portfolio Selection," 1952, 1990 Nobel Laureate
Cicero " Probability is the very guide of life. "
Cicero (106-43 B.C.)
Aristotle " The probable is what usually happens."
Aristotle (384-322 B.C.)
Karl Pearson " The record of a month's roulette playing at Monte Carlo can afford us material for discussing the foundations of knowledge. "
Karl Pearson, from Lady Luck, the theory of probability by Warren Weaver
H.G. Wells " Statistical thinking will one day be as necessary for efficient citizenship as the ability to read and write. "
H.G. Wells
Warren Weaver " One of the most striking and fundamental things about probability theory is that it leads to an understanding of the otherwise strange fact that events which are individually capricious and unpredictable can, when treated en masse, lead to very stable average performances. "
Warren Weaver, Lady Luck, the theory of probability, 1963
Louis Pasteur " Chance favors the prepared mind. "
Louis Pasteur (1822 - 1895)
Gary Smith " Modern physics uses the normal distribution to describe the movements of molecules. The motion of each individual molecule is quite disordered, and yet their overall behavior is very predictable. This disordered movement is known as random walk. The idea of random walk was actually used by Laplace and others to analyze a gambler's chances of wandering into bankruptcy. Today, the random walk is applied to many phenomena, including the stock market. "
Gary Smith, Statistical Reasoning, 1985

Musing on the Joys of Bear Marketsto top

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