theshaded1ne - Tumblr blog

theshaded1ne · 6 years

Text

Risk – Return Incongruence

In speaking with many of my colleagues and friends, along with observing discussions on social media, it has been reinforced to me that the relationship between risk and return is seen with a tinted lens. Risk and return have many quirks and inconsistencies that make the relationship, and thus the understanding of, risk and return very vacuous and hard to understand.

Unbalanced Distribution of Risk vs. Return

Balancing risk and return is a cornerstone of investment decision making theory, going back to Harry Markowitz’s paper “Portfolio Selection” from 1952 and William Sharpe’s self-named Sharpe Ratio from 1966. That being said, risk and return are still not equally taken into account, specifically in that the opportunities for outsized return are publicized and stressed much more often than the downside risk associated with these opportunities. In fact, many of the underpinning formulas and equations in portfolio theory assume a normal distribution of returns, and as we have seen on multiple occasions such as Black Monday in 1987, and even some of the more volatile days in 2018, the market seems to have kurtosis on the downward end of the standard distribution spectrum. What I mean is that the market seems to have a tendency to have outsized downward turns, which conventional theories of portfolio selection would not be able to compensate for. When a set of data points continually deviates from the norm, it would be a fallacy to continue to call it “standard” as that would imply that the data is following the bell-shaped curve that is correlated with a standard distribution.

What is the outcome of this uneven comparison of risk in theory versus reality? An incongruence between what risk should be, and what risk actually becomes in truth. Not only is risk not well modeled from a professional setting, but from an individual investor standpoint, risk is hard to fathom in comparison to return which is much more concrete. It is somewhat simple to project scenarios where an asset you are researching grows beyond what investors predict from an earnings-per-share or revenue growth standpoint, which would cause an appreciation in the value of an asset. By comparison, muted growth, acquisition, or unforeseen and difficult to quantify factors such as political effects can be guessed upon but are not easy to represent well in a forecast.

Perception of Risk

Due to the difficulty of modeling and forecasting risk, there becomes the obvious trap of downplaying risk through omission. Omitted variable bias is a leading contributor to low correlation coefficients in OLS analysis in statistics, and if omission is difficult for professionals, then laymen who invest out of a passion and not a profession will have equally as much if not more trouble with the tendency to omit risk. As I have mentioned before biases like survivorship bias and heuristics such as anchoring, the human mind already tends to set boundaries based upon what we perceive from our impressions of an asset, which may not be grounded in the fundamental value of the asset, but rather from a bounded rationality that we set based upon observations of the asset in the short term.

Lets give an example for reference to why this incongruence can make one misperceive risk versus reward. Think of one of the oldest get rich quick schemes in investing, penny stocks. Often you will see advertisements and articles about the next big penny stock, and the temptation is that, because penny stocks are so cheap on a per-share basis, that overall the risk of the stock is less compared to the potential return. Now, if you compared penny stocks to value stocks in the Dow 30 in the short term, this may actually be a viable conclusion to make about penny stocks. However, over the long haul, larger value stocks do not have nearly the downside risk of a penny stock. Another point of contention is the feeling that penny stocks have much more upside potential. Sure, a stock priced at 25 cents that jumps to 50 cents in a day has increased by 100%, and that is much more of a likely occurrence than a 25 dollar stock on the S&P 500 increasing to 50 dollars in 1 day. However, the chance of a stock priced at 25 cents dropping to 0 is significantly more likely to occur than a stock priced at 25 dollars to 0. The salient point here is that, though there are sharp upticks by these penny stocks that may cause them to seem like gold mines, the opportunity for complete failure and loss of your entire investment is also significantly more likely!

Conclusion:

Risk and Return do have strong ties to each other, and maximizing return while minimizing risk should always be the goal. Even if you are willing to take on more risk, wouldn’t you want to look for the most return for each risk profile? The important fact to consider, and what has been pushed throughout this piece, is that you should spend far more time on the potential risk factors in your decision than the potential return factors. Getting a strong ROI may be the sexy choice for your analysis, but over the long term, minimizing risk will be the successful one.

#finance #Risk #writing #decision making #investing #statistics

0 notes

theshaded1ne · 6 years

Text

3 Steps to Take Before Making an Investment Decision

When beginning to invest, there is a large amount of anticipation about the event. What to buy, which service to use, and how much to invest are major decisions and should be taken seriously. However, there are certain preparatory steps that far too often are overlooked. Here are 3 Steps that need to be taken before any investment is made.

1.Set specific, actionable goals:

As an investor, having a list of actionable goals is critical for long term success. First of all, creating goals breaks the long-term process of investing into partitioned units that are easier to measure. If one has an actionable list, like a year over year percentage growth goal, or a certain contribution amount into a 401k, it is much easier to stay focused and make sound decisions when investing. Without a set plan and goals, there are a multitude of short-term opportunities to make decisions that clash with an investors long-term goal of financial stability.

One helpful tip to keep goals in mind is to go over your goals again every time any significant investing decision is made. This reinforces in your mind that the move being made is aligned with your long-term aspirations, and can also dissuade you from making an ill-advised short-term decision brought about by changes in the market.

2. Define the Time Commitment You are Willing to Make

Time is an extremely valuable resource. With much of a working adult’s day tied up with their 9-5, travel time to and from work, along with family responsibilities, choosing how to spend any spare time is a very important choice to make. That said, investing, especially in the stock market, is a time intensive exercise. Therefore, it is important to define how much time you are willing to commit to investing. If you have lofty goals of picking stocks and “beating the market” (I.E. outperforming a stock exchange benchmark), then you also need to be aware that the time required to do so is much higher than if you were to take an approach such as ETF or Mutual Fund investing. Often, investors fall into the trap of wanting to pick individual stocks, but quickly find out that to truly feel confident about their allocations, they would need far more time than they actually have available to vet their decision making via data analysis.

Using the resource of time is critical for investors, and the feeling of not having enough time can lead investors into one of two pitfalls:

a. Quick, ill-informed decisions that in many cases violate the investors individual risk tolerances just to feel like they are keeping up with the current situation in the ever-changing market. Often one will notice darlings of the market come and go, and while they may be proselytized on business shows and be on the front page of investing websites, these market darlings also can quickly drop from their precipitous heights, causing many individual investors to take a loss on a company that, if they had more time to research, they may not have decided to buy in the first place.

b. Information paralysis, whereby the investor doesn’t feel confident in their research, but doesn’t have the time to do enough research to ever feel confident, and thus ends in a constant cycle of paralysis where decisions aren’t able to be made. Eventually, this can lead to frustration or desperation, which then can complete the circle back to option A where an ill-informed decision is made.

Making a time commitment is a basic building block of a strong investment strategy and can help avoid much heartache and indecision in the long run. If you don’t have time to manage your investments at a granular level, there are many firms and individuals who are more than happy to do so, as well as other investment methods like ETFs or Bonds that have lower risk and are less time-intensive. Though these options may slightly lower your expected return in the long-run, the decrease in risk and emotional peace of mind will be more than worth the downside (More to come about the Risk vs. Reward Proposition in another article).

3. Know Yourself

As an individual looking to start investing, the first place to start is not by looking outward for information, rather by looking inward. The first two tips have been focused upon coming to an understanding of what your goals are in investing, and how much time you are willing and able to spend achieving the goals you have set. This third tip will help reinforce the two above, and make sure that your goal and time setting objectives are concrete and sustainable and not overly optimistic, pie in the sky goals that you will not actually be able to achieve.

Knowing Yourself calls for careful introspection. Truly examine yourself and your tendencies, and this will help you to shape a more well-rounded picture of your personal investment outlook. For instance, do you tend to micromanage heavily? Does this need to be in personal control of every aspect of your finances cause you to vacillate between investment choices and not stick with a certain plan of action? Do you make decisions purely based upon recommendations from investing websites or conversations with friends whom have shown an interest in the market? Do bad days for stocks in your portfolio make you want to sell the stock immediately? Ask yourself questions like these, and write down your answers. Use this material as a reference each time a decision regarding your investments comes up and you will be able to identify certain pitfalls that you as an individual fall into and avoid them. In my own personal case, when thinking big-picture, I would consider myself a somewhat risk-averse investor. However, often I find myself persuaded by popular news stories and too good to be true stocks. To combat this, I physically print out my goals that I have set for myself and have them in view as a physical reminder of what I am trying to do with investing and to stay on the path I have set. Over time, this repetition lead me to a more consistent outlook, and kept me on track with my long term goals. Conclusion:

Investing is a great venture and full of opportunity for wealth creation. However, there are downsides to everything and investing is not without significant risk. One of the best ways to create a winning mindset as an investor is to set goals, understand the time commitment that you will need to reach your goals, and to know yourself and your own personal tendencies. With these internalized values in mind and repeated throughout your investment journey, you can feel that much more confident of success as you step out into the wild world of the financial markets.

#finance Investing goalsetting longtermmentality

0 notes