Morningstar Advisor - April/May 2013 - (Page 36)
Spotlight
Risk On/On Risk
By Hal Ratner
Every investment decision you make is a verdict on risk
and uncertainty.
The credit crisis of 2008 made investment risk
de rigueur. The proliferation of volatility
controlled and lower-risk alternative strategies,
coupled with the entrance of terms such as
systemic risk, liquidity trap, and risk aversion
into common parlance, has signaled a change
in how investors think about risk.
When we speak of risk, we tend to mean
downside risk. This is, of course, an incomplete
picture. In simple terms, risk is the degree
and magnitude to which an event differs
from what you expect. Formalizing this as some
sort of probability distribution—perhaps a
bell-shaped curve—we can see that all
investment decision-making originates
with some inference about the magnitude and
likelihood of some event or set of events.
The three histograms on the next page loosely
illustrate this concept. In the first graph, we
posit all possible events that could occur over a
given time period, in this particular example
the three-month return to global equities. In the
second graph, we assign probabilities
to each of these events. This is a fairly general
exercise, but what distinguishes investment
decision-making from many of its fellows
is illustrated in the third chart. Here we apply a
risk-aversion function to each event.
This function accounts for the level of risk
aversion that someone investing in the market
36 Morningstar Advisor April/May 2013
brings to the investment experience. Assuming
a relatively high level of risk aversion
(in this case a risk aversion coefficient of 8),
the 1% chance of a 22.9% drop in the market
now becomes a 1% chance of a 54% loss
as experienced by the risk-averse investor.
The expected utility of this scenario—found by
summing the actuarial value of each utility
adjusted return—falls from 4.02% to
0.16%. If the investor had almost no risk
aversion, the expected utility would fall only to
3.6%. Investment risk is how you experience
market fluctuations—it isn’t an objective state
of affairs.
In other words, investment risk isn’t simply
the variance of returns. It is the value
each principal assigns to a given scenario.
A risk-neutral investor, if such a beast
exists, experiences the variance in his or her
portfolio as the calculated standard deviation,
or Value-at-Risk, of that portfolio. But the
risk-averse investor experiences variance
in a different manner. Investors are risk-averse;
they apply more weight to bad events than
to good ones. This is why when we talk about
risk we usually focus on the downside. It’s
more memorable.
the possibility of something utterly unprecedented happening. It is the possibility
of an event occurring that falls outside the
probability distribution.
This is more formally referred to as Knightian
Uncertainty, after Frank Knight, the University
of Chicago economist who introduced
the concept in his 1921 book Risk, Uncertainty
and Profit. Knight was trying to explain how
profits were possible given perfect competition.
If everyone observes the same probability
distribution and is motivated to maximize
profits, the traditional model says profits should
be driven to zero.
In Knight’s view, the only thing that could allow
for profits and perfect markets was the
occurrence of an event entirely outside
the probability distribution—an event without
precedent that could not be quantified or
imagined by anyone.
Risk vs. Uncertainty
Knightian Uncertainty is a powerful concept
precisely because the process by which
investment returns are generated is ever
changing. We can tell you precisely
what happened (and if you’re lucky, maybe
even why), but we can rarely tell you what
will happen with any precision.
The term uncertainty is often used synonymously with risk. But for investors, it is important
to define uncertainty as something else—
This is so for a number of reasons, not least of
which is that the market is subject to a
Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013
Morningstar Advisor - April/May 2013
Contents
Contributors
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot
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