Sunday, February 06, 2005

Subjective Risk

Traditional economists, in the spirit of the natural sciences, measure investment risk by calculating the volatility (standard deviation) of returns. What all economics and business students are taught is that the higher the risk of an investment, the higher the expected return. In practice, we are told, investors seeking higher returns should be prepared to take on higher risk. I find this "objective" view to be misleading and not very useful in practice.

Admittedly, it is convenient to use historical price data (time series) to derive volatility and analyze investment returns. However, as we all know, history is the past, and what really matters in investing is not the past but the future. Traditional analysis uses past data to construct probability distributions describing where future prices might end up. In actuality, though, only one price path occurs--asset prices only follow a single path, whether it be up or down or roundabout. Those investors, who by luck or foresight are on the correct side of the market, profit from this actual price movement.

It often happens that successful investors, in hindsight, will say that they "knew" or at least felt very strongly that a stock would rise, and that's why they bought when they did and how they made the money that they did, while others sat on the sidelines, unwilling to risk their money on such an what was in their view an uncertain outcome. What is going on here is that investors have different vantage points and really are effectively NOT all working with the same information. Sure, basically the same information is available to all investors but, as a matter of fact, different people access and process information in different ways and end up with different assessments of the risk involved in any particular investment.

In other words, perception of risk is subjective. What one investor may see as very risky, another investor may see as having a very different risk profile. Like a tightrope walker who is able to perform on the highwire, while the average man would quickly lose his balance and fall, the investor with special insight into a particular situation or company is the one who climbs on board when others won't and ends up reaping the excess profit.

To sum up: High risk investments for the majority can actually be low risk investments for individuals with special insight into the particular situation. Successful investors are those who walk on tightropes familiar to them, staying on the highwire while others fall off.


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There are three distinct risks you must guard against; they are business risk, valuation risk, and force of sale risk.Investment Risk

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