Risk
(Also see this post.)
What is risk? In investment, the term is often used. “What is your risk tolerance?” is an example.
In reality, the chance of something occurring (as in a deterministic universe) might be 0 or 1. Typically, when people are talking about risk, they are talking about an estimation of the chance of something occurring. An estimate is a subjective evaluation - that is, it is based on the information the agent has about a system. Therefore, for practical purposes there is no ‘risk’ inherent in any investment strategy, only different risk evaluations based on subjective types or amounts of information different investment agents have.
Also, for different individuals, the objective riskiness of a given situation varies. For example, if you have never ridden a bicycle, the risk of hopping on one is fairly great. If you have learned how to ride a bicycle, the risk is fairly small. This is why extreme sports aren’t typically as risky as they seem. Similarly, in business, an entrepreneur may have systematically minimized the risks in various components of the enterprise, therefore making it much less risky than it may seem (or not, of course).
So, different individuals’ evaluations of risk (given a constant system) can differ (due to differences in information, simply put - obviously, it’s more than just ‘information’ but rather a relevantly adequate understanding of that system and its possible outcomes), and risk is relative to the individual interacting with the system in many cases.
Typical analyses of ‘risk’ in various investments involve some assumptions about the information levels available pertaining to possible outcomes. The idea that diversity of investment types reduces risk, for example, often relies upon the premise that information about possible outcomes in specific areas is of a low quality. If, on the other hand, you have relevantly important information about a specific type of investment, the risk of investing in just that type might be very low relative to the risk of diversifying your investments to areas where you have less relevant understanding of possible outcomes.
Most investors have very little information about a given investment system and the possible outcomes. They hire someone, who presumably has a better understanding of the various possible outcomes, and in some cases has a better ability at interacting with the investment system (as in buying and selling at key points), and can therefore minimize risks for them and increase their return. The question for most investors, then, is what sort of investment of their own time would be required to significantly increase their understanding of some possible investment system, such as to decrease the risk involved for them in investing in it?
My guess is that it would not be that hard to get to the point where you can have less investment risk by doing this than what you would have by using the experts who are offering their investment services, typically. Maybe a few months of dedicated study? Financial investment in many cases is basically recognizing potential growth and value in a company. Similarly, the value in trying to understand broad, abstract financial systems may be overrated.
In short, risk tolerance is usually posed against a backdrop of a notion of objective risk. In reality, subjective appraisals of risk (”subjective risk”) in these products can shift sharply, as a given agent’s understanding of the financial systems involved becomes better (or worse). Understanding of the risks involved in a diversified investment portfolio means multiplying the investment areas to understand (or having to understand ‘higher-level’ financial systems, which might be more difficult to understand than more contained financial systems), which can result in increasing the subjective risk. In other words, beware of financial maxims that involve very complex systems.
6. April 2009 at 14:50
“My guess is that it would not be that hard to get to the point where you can have less investment risk by doing this than what you would have by using the experts who are offering their investment services, typically. Maybe a few months of dedicated study? Financial investment in many cases is basically recognizing potential growth and value in a company. Similarly, the value in trying to understand broad, abstract financial systems may be overrated.”
This is a difficult question to answer.
Funds with large numbers (>20) holdings are virtually guaranteed to regress to the mean. Usually large funds have investment committees running them, which also is likely to result in average performance (minus management expenses).
There are a lot of “little tricks” that the average person would have no clue about by studying books and as such about investing - I don’t even think professionals know most of the tricks either, especially if they are not ‘numbers’ people.
The best way to outperform is to concentrate your positions. It is also a higher risk approach. The best analogy is “keep all your eggs in a few baskets, but watch those baskets very carefully”.
But in terms of “finance professionals”, most of the value the industry creates is in marketing (i.e. giving somebody the feeling of “safety” or “growth” or “ethical investing”) rather than actually providing value to their customers in the form of above average returns.