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Risk, Volatility, and Value

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By whatismyoption
April 18, 2008

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Last night just when I wanted to close my eyes and go to sleep my wife asked me how risky our investments are. As my dearest almost never asks about our investments I found this particular question and its timing quite bewildering. Bloody mass media and credit crunch. When it comes to our finances my clever, widely read, successful, gorgeous wife wants things explained in very simple terms. Most of the time she wants answers in a single word, one sentence at most. I know she wanted to hear "not risky" and despite that being my belief I could not give her that answer.

So what was my problem with telling her what I believe to be true and what I know she wanted to hear? My problem was I know she has a completely different view of risk than I do.

So today I spent all of ten minutes researching risk in the hope of crystallizing my thinking. Google eagerly pointed me to the seminal paper on risk by the father of modern portfolio theory, Harry M. Markowitz's Portfolio Selection. I tracked down a copy here.


Instinctually I had always assigned MPT and the association of volatility with risk as academic folly. In recent years I felt encouraged reading Buffett, among others, articulately illustrate the folly of volatility as a measure of risk. Before reading Portfolio Selection I thought I'd take a couple risk assessment tests, like this one from Westpac.

Taking this test made me realize why I couldn't tell my wife that our investments were not risky. Each test I took told me I was a "very high-risk investor", while I believe I am a medium risk investor. Looking at the questions I realized they are framed with volatility and not value foremost in mind. It was then I realized that is the difference between my wife's and my perception of risk. The classic opposing views of volatility and value.

I'm not sure if my loved one slept soundly or not after I closed our discussion by saying I'd welcome a massive market sell-off even if it meant our liquid net worth was halved.

For now I've decided to engage in some confirmation basis and re-read Buffett's 1993 Shareholders letter prior to reading Markowitz's Portfolio Selection.

After that I plan on determining my overall beta and applying anything I learn in Portfolio Selection. Then I'll compare that with my combined margin of safety score that I regularly maintain. I doubt that will tell me much, but if I find I have a high beta then maybe I'll look for more confirmation that it's margin of safety that counts when thinking about risk. The last thing I want is to have years of positive market beating performance dissed as mere beta. Actually the last thing I want is another colonoscopy, but both remind me of the same thing.

Cheers
Dean

PS How do people here define their risk? Does anyone have risk a assessment questionnaire based on value rather than volatility. Thoughts?