FYI: Of the many lazy and dangerous ways of thinking about investment these two rank near the top: that risk equates with volatility and that risk and rewards are a straight tradeoff.
Both are overly simplistic and both lie at the heart of some of the most colossal errors in recent finance. And while both contain large amounts of truth at their core, both concepts represent shorthand versions of reality rather than tools which always, or even usually, work.
Regards,
Ted
http://blogs.reuters.com/james-saft/2014/09/10/never-confuse-risk-and-volatility/?print=1&r=
Comments
OJ
However I think this has been said before about volatility and risk not being the same. A certain bald person has also said it but unfortunately he is infamous.
Is there actually anything that "hasn't been said before"??
The spotlight shines on the winner but never mind all those who helped the winner get there.
Don't know how to link podcasts, but I think this is the same one.
http://www.npr.org/programs/ted-radio-hour/321797073/what-is-original
I learned about the trendiness of bond funds, especially junk, from my very first trade in PRHYX back in January 1991. I think it went something like several months of either up or unchanged without any down days whatsoever. It was love at first sight! Then I recall when Strong opened up their first junk bond fund. The first year it was up over 26% without so much a 2% drawdown along the way. And yes, diligently monitor a host of open end bond funds of all colors and stripes daily as well as ETFs intraday. Albeit when it comes to bonds, especially junk corporates and junk munis, I am very outsproken that you don't want to go the ETF route.
Our recent MFO discussions that center more on the originality of the market commentary and observations tend to detract from the main themes of the subject works. That’s a wasteful distraction.
Original thinking on any subject is rare. If the communication requirement is originality, a room filled with clients would be mostly silent; a written report to clients would be mostly a blank sheet of paper.
Originality is nice and in some instances is necessary, but it surely is not a prerequisite when communicating for informational or even for persuasive purposes. Sure things change, but not that rapidly. What has happened in the past (history), and what has worked in the past provide a firm basis for what is likely to happen in the future. At a minimum, it is an excellent point of departure for planning purposes.
The key point here is that the referenced James Saft article emphasizes the shortfall of return’s volatility as a total measure of investment risk. That shortfall has been recognized within the investment community ever since it was proposed as a partial risk measurement back in the 1960s (Harry Markowitz and others). It definitely is not original stuff.
Note that no expert suggests a total discarding of volatility as a risk component; they merely argue that it is incomplete in that it does not capture all the interactive elements of it. Risk is a complex, multilayered phenomena, and is likely dissimilar for different folks.
The Saft article was okay; it did draw heavily from an Oaktree clients report written by Howard Marks very recently. The Marks report is excellent and develops a risk assessment concept much more completely than does Saft. If you enjoyed an/or learned from the Saft piece, I suggest you access the Marks document at:
http://www.oaktreecapital.com/memo.aspx
The arguments assembled by Marks are not new or even novel. These things evolve over time. However, in the Marks paper, they are cobbled together in a way that just might provide an improved risk guidance for your portfolio investment goals.
In the middle of the report, the graph that depicts the risk/reward tradeoffs yields a particularly useful picture at how the statistical distribution of expected returns more correctly overlays the reality of that tradeoff. Please take especial note of it.
The more careful collection of the data, the interpretations of that data, and the extrapolation (the most dangerous aspect of the entire process) of these interpretations (dare I say a model?) make revisiting the data and some recent analyses worthwhile. Since our recall is imperfect, and since our needs change over time, this revisiting is necessary and sometimes even profitable for investment decision-making. None of this probably qualifies as highly original thinking. That doesn’t trouble me whatsoever.
Care and precision must always be exercised when presenting data or an argument based on that data. Definitions are critical. The risk debate effectively illustrates the requirement for meticulous definitions. Along those lines, Morgan Housel recently published a list of “Things You Should Know the Difference Between”; these items do make a difference. Here is a Link to it:
http://www.fool.com/investing/general/2014/09/09/things-you-should-know-the-difference-between.aspx?source=iaasitlnk0000003
These days, it seems we are all fretting over the next looming market decline. The known unknowable is that it will surely happen; the unknown unknowable is its magnitude and when that will happen. Market decline history provides guidance in this arena. There is certainly no originality buried in these data, but they do directly bear on the downturn frequency. From a statistical perspective, these data establish a base-rate.
The data I quote come from the American Funds and includes the timeframe from 1900 to 2013.
A 5% downturn blip has occurred about 3 times a year; a 10% correction about once a year; a 15% downdraft about once every two years, a 20% Bear market approximately once every 3.5 years; and a 30% panic about once per decade.
These are all merely averages so beware the distribution element. These negative outcome stats do yield an overall context. Over short periods, the spacing and durations are somewhat haphazard, so money reserves are needed. That too is not original advice since it dates back to the Talmud as I reported in an earlier post.
I hope you guys enjoy and profit from the references. It’s far less important that you enjoyed my submittal which contains no original thoughts. I offer no apologizes for my lack of originality. Good luck to all.
Best Regards.
Here's an example of both conditions in a fund I own, BUFOX.
Here's a 5 year chart of USBLX and PONDX that speaks for itself:
Or, one of Ted's favorites, PRHSX, in a three year chart (this fund's chart is "pretty" all the way out to 20 years):
I totally agree with Kaspa that the charts on this exchange are “Pretty charts too!”.
At issue is if these “pretty charts” can be functional and profitable money making charts too. In this regard, the evidence is not clear. That depends on what actions the chartist implemented when the designated “linear” lined channel formation was violated and what were the profit/loss outcome from that specific action.
The chart itself is yet another stellar example of a product that contains zero original data. Standing alone, it is simply a graphic summary of historical pricing information. The chartist and technical analyst hopefully adds value to that pretty picture by drawing “linear” lines and making some interpretations of the general patterns he sees in the overall data summary.
The graph itself is just old stuff; the interpretations aren’t especially original stuff either since they are based on historical precedents. Hundreds, maybe thousands, of these precedents exist in the chartist’s playbook. These precedents do change over time, but only very slowly. The trustworthiness of these patterns to project future performance is the basis of much heated controversy. Credible proof is elusive.
Note that I highlighted the “linear” character of the data interpretations. In reality, the interpretations are not linear, but are highly non-linear because the graph paper typically contains a linear horizontal scale, and a logarithmic vertical scale. That converts a linear relationship on the graph paper into a non-linear dependency in the real world.
Economists hate this. The non-linear nature of any prediction obscures any errors introduced by the plotting technique. I’m sure many MFOers are familiar with this effect. Again, I’m not offering any original information on this matter.
A chart is just a way to nicely summarize existing data in an organized manner. What a chart user does with the historical data can be useful, but it also can generate a dangerous projection. Non-linear extrapolations really need a fairly refined model if they are to be trusted.
The danger level always increases as the timeframe expands, especially if that user doesn’t understand the basic character of the extrapolation process employed. Some math is essential to that understanding. When using charts, be careful guys; be very careful and use additional decision criteria to reinforce any chart signals.
Best Wishes.
Microsoft goes down 50%, Goes up 100%. Back to square one. Volatility High. NOT RISK.
Enron goes down 50%. Goes down another 50%. Goes down another 50%. Goes Bankrupt. Volatility High. Permanent Loss of Capital. RISK
Nice.
Those who can figure out which while it's happening will make good active investors, especially those that can do it consistently...or at least more often than not.
Mr. Rolfe of RiverPark Wedgewood made great active call with Apple recently.
Mr. Berkowitz of Fairholme a while back with Bank of America.
And they had the courage of their conviction. Certainly not easy.
May not be complicated in theory, but in practice...
Charles has a interesting view on this. If the investor had the expertise or luck to get out near the top and be able to get back in at or near the bottom they are taking a risk that it might be different this time.
We have a lot of large growth tech stocks that have not seen their highs since dot com bust. If no new money flows occured, and the fund which held such stocks still existed, it would be a losing proposition - permanent loss of capital. We know that most of such funds have long gone out of existence.
It is same thing. WHEN vs WHAT. Manager risk cannot compensate 100% for market risk. Funds WILL go down. What us active investors need to do is accept Manager risk to recover from the lows instead of accepting Market risk and the volatility it offers.
Thanks for your comments.
Perhaps my remarks did not properly represent the main purpose of my posting. Although model linearity was not the primary motivation of my note, it was definitely more than a quibble. In most projection applications, the difference between a linear and a non-linear correlation equation is huge and meaningful.
The choice of the graphic format should be to facilitate an explanation, but it can also be selected to distort the reported findings. An exaggerated scale can make modest data scatter appear to be unreliably tsunami-like. Truncating the scale by not including the zero point operates in a similar way. Buyer beware of plot scale tricks.
My primary purpose was to simply buttress the obvious; a graph of price data or cumulative portfolio value just reports past performance. It is a record of what has happened in a structured manner. It contains no original thoughts.
My commentary about the interpretation of straight lines drawn on graph paper was definitely of second-order significance. A straight line imposed on standard graph paper signifies a linear algebraic relationship between the variables; a straight line drawn on specialized semi-log paper denotes a non-linear relationship between the variables depicted on the graph. I wanted to emphasize that disparity since it impacts any rate of change projections.
If a straight line adequately models the data on standard graph paper, then the rate of change is a constant. The slope of that line is the desired rate of change estimate. If a straight line adequately models the data on semi-log paper, then the rate of change is a constant times the local value of the dependent parameter. This result comes directly from application of Newtonian Differential calculus.
My comments were made to highlight this rate of change differential effect, nothing more sinister intended. A successful investor demands to know why and how some event happened to supplement the “what” happened information. Everyone has the “what” happened data. The “why” and “how” potentially gives the active investor his edge over others.
As Charlie Munger observed: “It’s not suppose to be easy. Anyone who finds it easy is stupid”. That’s harsh. Perhaps that “anyone” is just plain lucky, but luck is not sustainable.
When I was in graduate school I managed a data analyses group for an economist to supplement my income. He was dedicated to linear cause and effects, He went wild and rejected my analysis whenever I presented him with a non-linear correlation. He felt these correlations just got out-of-control far too quickly. He and I never really got along very well, but I did eat better because of the employment.
Best Wishes.