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On Defining Risk



July 14, 2014 – Comments (2)

Board: Macro Economics

Author: PosFCF

As an individual investor and, then later as a professional advisor, I have wrestled with the definition of the word "risk" as it applies to one's investments.

In a recent comment on another thread, Wendy said (in part) the following: A portfolio can be less risky (that is, its beta can be reduced) IF the assets are not correlated.

Embedded in this comment are two of the main paradigms that seem to be the accepted Street wisdom on defining "risk": Beta and asset correlation.

I have a real problem with using Beta to define risk. Mainly, I guess, because I think more like an owner of an enterprise rather than as a trader of vehicles. As an owner of a business, it really doesn't matter much to me if Mr. Market is manic one day or week or month and depressive the next corresponding period. It might matter if I see either the manic or depressive influence take the price to the enterprise to levels of valuation where they are (by me) considered so absurd that I am almost forced to act (sell or buy more, depending).

The problem I have with correlation is several fold: first diversification of assets just so that I have money divided among supposedly uncorrelated (or lowly correlated) investment vehicles may be either brilliant or stupid depending on timing. Remember in 2008-9 all assets were proven to be correlated, so that should give some of the staunch asset allocators pause for thoughtful reflection as to the merits of the underlying thesis. So asset allocation leading up to that period may be considered of dubious merit.

If one is such that they do their own homework and are constantly on the prowl for mispriced opportunities, then asset diversification generally occurs over time and I tend to think of this type of diversification as more toward the smarter side of the allocation process.

However, if one doesn't know enough to do their own research, and depends on "professionals" to provide their allocation models, since 80% of "professionals under perform the benchmark index against which their performance is measured, I would consider this to be on the less smart side of the equation.

I have been participating in the board (with several periods of pulling away from the Fool altogether) for quite a few years. I do not remember having any detailed discussion of how we each and, perhaps, collectively define the last word of our boards name: "Risk".....does it have a different definition for individual portfolios than it does for macroeconomic trends? If so, should we state which definition or context we are using in any given thread?


2 Comments – Post Your Own

#1) On July 16, 2014 at 4:14 PM, dtgusa (76.12) wrote:

Good day to you,

I am a tad perplexed.  Oh, I agree with you pertinent to beta, correlation and indicies.  I gave up on beta when I took back control of my investments.  Your point on correlation was well made.  Indicies are eschewed in favor of an individual holding's intrinsic value appreciation over the long haul. (Oh, it is fun playing My Caps against the S&P 500 but...)

I do wish to quibble with, "If one is such that they do their own homework and are constantly on the prowl for mispriced opportunities, then asset diversification generally occurs over time and I tend to think of this type of diversification as more toward the smarter side of the allocation process."

Defining terms - it is assumed that one researches and understands what it is a company does for a living as part of exercising due dilligence / homework before buying that company.

Mr. Buffet has stated (paraphrasing) he does not buy companies when he does not understand what it is they do for a living, e.g. until recently he did not invest in tech firms and look at which firm he selected when he did venture into that sector.  If one is exercising due dilligence and doing their homework, as defined above, over time a concentration in areas within the individual's areas of expertise develops. 

Granted this process may span several market sectors.  Transnationals may provide some diversification by their nature; 3M and GE being a few quick examples. None-the-less, a few market sectors within one's areas of expertise does not seem to qualify as diversification as it is generally used  today. 

Having registered my quibble with the use of diversification being unrealized as defined above I propose a follow up examination of Modren Portfolio Theory (MPT) to which the concept of diversification is attributable. A quick internet search will provide the widly held tennents of this theory. (Being new here I do not know if I can post URLs or not so I didn't.)

I offer for consideration that MPT based diversification, like comparisions to beta, correlation and indicies are artificats of traditional broker centric trading models.  "You only need a few good stocks in your lifetime." Peter Lynch

Obviously, my thinking on the value of MPT's use of diversification is leaning toward abandoning it too.  Yet my portfolio is only 65% stocks, weighted by total value, so I am undecided at this time. The fulcrum is results over the last six years; six years because that is how long I've actively monitored my holdings and then three years ago took over my investments. 

When the market goes up or down that 35% does not go up or down with it, or does so slowely.  In essence, it is doing what MPT provides it will do.  The trade off seems to be limiting both upward and downward peaks in my portfolio.

Yet, based on my results from 2011 I have to wonder what utility a diversification strategy provides and at what cost?  I'd sure like to read what others think about the value or lack of value incorporating a deliberate diversification stratey into their overall strategies plays.  I am inclined to discontinue it as was done with beta, correlation, and indicies.  But, with only three years expirence and that being in what is in essence a bull market I just do not have the information to decide.


I disagree with your posted idea that diversification will be obtained via properly researched investment.  I have growing doubts about even considering diversification in an investment strategy.  But, I just do not have the expirence to evaluate if my use of diversification is a hold over from broker centric investing.



 PS: That 65% is made up of 30 different companies and two ETFs.

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#2) On July 16, 2014 at 7:12 PM, dtgusa (76.12) wrote:

Good day to you,

Not sure how to edit a posted response or even if it possible here.

1) Apologies -- my personal assessment of risk is evolving and diversification is under the microscope so I focused on that aspect of your question about risk in my first post.

2) In direct response to your question about definitions of risk and macroeconomics.  My answer is it is contextual; a definite maybe.  Please allow me to explain.


A. My personal risk tolerance is reflected in my investments.  The brokerage firm I use to hold my account defines me as highly risk tolerant based on several factors that have nothing to do with macroeconomic factors.  Yet, I consider myself very conservative based on what I am willing to pay for a business I wish to own.

B. Do I consider macroeconomics when buying a business?  Yes. 

Three of my trades that may be speculative / high risk are AA, LYG and MT.  Among other factors considered when purchasing them were macroeconomics, i.e. what they do for a living is directly impacted by macroeconomic factors.

Depending on where you draw the line between macro and micro economics the recovery of these firms to their intrinsic values are based on Country or Global risk assessment.

For want of another example of macroeconomics and geopolitical risk being a consideration one need look no further than the oil industry.

3) So to answer your questions: 

A. "Risk".....does it have a different definition for individual portfolios than it does for macroeconomic trends?"  Conditionally, I offer a yes.

I offer for your and others consideration and hopefully further discussion that risk as used here is looking at metrics to assess and make investment choices.  The weighting given those metrics are of a personal nature and as such are weighted according to the individuals personal comfort zone.

If one incorporates economic considerations when assessing a prospective business to purchase or sell it falls under an individually defined usage of risk.  Please note: economic factors are not financial factors rather they impact a businesses profitability or lack of it. But...

Economic risk factors be they micro or macro in nature can encompass such things as "Country Risk" and or "Geopolitical Risk."  As an example, when purchasing AA two of the factors considered were the global recession and what the heck China was doing.  So if you had posted an article on AA discussing those things the odds are you would be using both macro and micro economic risk assessments.  How I weighted those risks to decide on investing in or selling AA would be my personal definition of risk.  I hope that made sense.

B. "If so, should we state which definition or context we are using in any given thread?"  Yes.  Assuming the thread does not already do that for us. 

If I post a discourse on country X's Country Risk assessment here without placing it in context it might be removed as being off topic.  By way of example China was producing vast amounts of aluminum dragging down the price for it.  But, business loans in China can be secured by commodities held by the company taking out the loan. If I posted that here the context would be for investment considerations.  If I posted it in a diferent thread it could be financial or geopolitical.

I respectfully offer for your consideration and further discussion, under the heading of defining terms: where do you draw the line between macro and micro economic factors in the context of investment decisions; and, what components of those economic variables do you place in either category?  Between this and the previous post I’ve shared examples of how I weight economic risk factors in my risk assessment for an investment.  (It all depends on what the company being researched does for a living.)  I’d value your ideas so I can improve my assessments.  For that matter I’d value your ideas on risk assessment metrics in general.

In closing, once again accept my apologies for focusing on a specific risk assessment measure you mentioned in your post.  Please accept this post as part of my initial post. 



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