Risk does not necessarily mean it will happen. It means it has the probability to happen as a range of outcomes. Because among those outcomes only one will materialize, people often forget and/or underestimate what might happen.
We separate risk from uncertainty. Uncertainty is measured by variance or standard deviation. Take variance for example, variance measures the various degree of outcome (thus comes the term variance) comparing to the mean. Outcomes involve around the mean can come in upside as well as downside. Let’s say investors invest in the stock market with expectation to earn 7% a year is the mean, then a return of 9% of a particular year as well as a loss of -3% of another particular year are outcomes of variance. Mean outcome does not mean that the outcome will come out as right at the mean. Some years it will above the mean, some years it will come below the mean; but averagely all of the good and bad will average down to the mean as expected return.
Risk does not mean variance or standard deviation, even though traditional finance metrics often use standard deviation to measure “risk”. Increase variance increases volatility, and in term, increase both the expected downside and the expected upside. When an investor invest with the expected return of 7%, a return of 9% will not be considered a risk-outcome has materialized. The investor will enjoy this upside variance, thinking herself genius. When an investor invest with the expected return of 7% and come a return of -3%, this downside variance will be seen as a risk-outcome has materialized. As you see, upside variance is not the risk we worry about. If volatility comes and gives me the chance to increase my expected return of 7% to 9% year in and year out, I will be happy to increase volatility of my portfolio to the max. The issue is, when increase volatility, we do not know what will happen among a range of probable outcomes: +9% will come? +11% will come? -8% will come? Or -3% will come? Volatility is both your friend and foe. Risk, or the downside volatity, is your foe alone.
The tricky part of dealing with risk is to understand that risk is not the single final outcome that comes out in the end. Such as in the above scenario, in one particular year, the realized return is -3%, this is a loss but not a risk. Risk is more than that. Risk does not black and white dictate a particular negative return. Risk is a range of outcomes that, depends on investors, return negatively of zero or below a certain benchmark such as risk free rate or index return. To say that to invest into Vietnam Stock Market that has the expected return of +7% and averagely of the down years, the index returned a loss of averagely -5% is underestimate the risks involved. That does not mean when investing into Vietnam Stock Market, the investor should expect a return of 7% on normal years and a -5% of a bad year. We will never know in advance how bad it can be and history crises are not indicative of future disasters. Future disasters can be worse. One prominent example of this statement is the crisis of 1997 and 2007. To Asian people, a crisis of the magnitude of 1997 had never been perceived to these young nations (Thailand, Indonesia, Malaysia, Korea, Russia post Soviet era). To the US, a crisis of 2007 is of magnitude of 1929 crash. I don’t believe anyone who is active in the market in 2007 have experience live what happened during 1929-1936. Even Warren Buffett and George Soros were both born after that (1930). So what happened during 1997 and 2007 were so new, so strange, and so novel to everybody. Thinking back on some of the major economic events, we will come to same conclusion: Black Monday 1987 market crash is the largest one day drop in percentage of DJIA – very novel, 2010 flash crash is another unusual risk-outcome that came alive – very novel and unprecedent in finance history, oil spikes during 1973 crisis resemble the oil price spike in 1861 in the United States – but again, noone experience both 1861 oil crisis and 1973 oil crisis.
How frequently these rare events, much worse than expectation comes around? Post World War II, we have Nixon Shock (1971) that led to US Dollar near crash (to date, it is the single event that led to nearly rejection of USD as the global currency, established after Bretton Woods in 1944), Oil Crisis of 1973, 1980 Latin debt crisis, 1987 market crash (world-wide, not only DJIA), 1990 Japan Stock/Estate Bubble burst (still on a prolonged loss-era after 20 years now in Japan), 1997 Asia Financial Crisis, 2001 Tech Bubble, 2008 Mortgage Crisis. Except a peaceful period from 1945 to pre-1970, we have 8 major global financial crises during the last 40 years. Now we should really start to question how frequently these rare events happen. My most plain and unsophisticated conclusion is that these rare things do come around so frequently.
Now let’s return back to 2005 and think of what is the probability of an event with the magnitude of 2007-2008 crisis to happen? The truth is on Wall Street there were a significant underestimate of risk in quant models among large banks and hedge funds. A magnitude of 2007-2008 is unprecedent to anyone who were participating in the market at that time, thus, noone ran a model with worst case outcomes that bad.
In this era of new complex geo-political delopments in the most recent years, I remind myself as a practitioner in the financial market that not to count too high on anything and to keep my mind open to any possibility. We don’t know what outcome will unfold among all possibilities and magnitude of bad case of scenarios are often underestimated: it can be worse than any bad experience ever perceived and worse than the worst case scenarios. Extremely bad rare cases do come around even though the probability for such event is low. Investors should be invest very cautiously all the time and try their best to understand what risks involved. As the old saying goes, it’s fatal not to know what you are doing and as you don’t see the risk ahead, it does not mean there is no risk at all.