Measuring risks to protect investment interests

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Many statisticians will tell you that you can measure risk in order to protect an investment, but there is actually no such thing. You can only really judge anything on its past history, but since random events may happen at any time, you cannot ever predict something based upon past history. Protecting means predicting. Predicting is impossible, so you are always at a disadvantage.

 

How Nassim Taleb explained randomness

You can look at the history of an investment and see that its value has steadily climbed up over the last few years, but that does not guarantee that it is going to continue climbing up. The investment may have reached its peak, or may soon begin its steady decent downwards. Nassim Taleb explained this sort of randomness with a Turkey example.

Every day the turkey is fed, and for a thousand days it is fed by the farmer. Every month the turkey is fed a little bit more, so that if you were to put the Turkey’s food consumption on a yearly chart, you would see the line going steadily upwards. On day 1001, it is Thanksgiving and the turkey is killed and eaten. Based upon the turkey consumption chart, the turkey may have assumed (based upon history) that he/she was going to continue being fed more. But, that was clearly not the case.

 

But there must be a way to measure risk

Not really. All you can do is base your assumption on history and hope that “day 1001” does not occur whilst you have your money within the investment. You can try using deviation to measure/judge an investment risk.

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A standard deviation is a measurement of dispersion. It is tracked as of the fund(s) return over a period of time. It basically tells you how volatile your investment is. If there is a large standard deviation then it means your returns are going to be unreliable, and if you are not a risk taker then you may wish to avoid an investment with a large deviation. On the other hand, a smaller standard deviation means that the funds return is more reliable and therefore a smaller risk.

 

A VAR method – Value at risk

This is where you judge the worst case scenario of loss and put it into a percentage. In other words, the higher the percentage then the higher the chance of loss. It is a risk management measurement that people use in order to judge a risk and figure out how bad it will be if things go bad really quickly. When somebody gives you VAR numbers they give you a percentage and then a dollar figure.

 

Money by George Hodan

Money by George Hodan

 

Your VAR numbers can be stretched out over months or years if you wish. For example, you could have one month with VAR numbers of 3% at $17,000. That means that the “worst case scenarios” is a loss of $17,000 during one month, and there is a 3% chance (or 0.03 probability) that this will occur.

 

Do not put all of your eggs in one basket

It is an old saying, but it still stands true in the investment markets. If you truly want to protect your investments then spread them, and do not just do it between different companies. Invest in different sectors/industries and under different schemes. Try a few risky and new investments and try a few time tested and “safe” investments.

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Be prepared to write off your money

If you are prepared to invest your money, then maybe you should be prepared to write it off. The fact is that risk is very hard to measure, and most statistical formulas simply there to make the investor feel better. Why not take a look at the worst case scenario for an investment, and if you can stomach it, maybe you should invest.

For example, if you are buying shares in a company, then look at its share prices over time. It probably goes up in a fairly random manner, but stretched over a long enough period of time it looks like a consistently straight line. Now look for the all time low price over the last five or ten years (assuming the company has been going that long). What is the lowest price that the shares have dropped to? Ask yourself if you could stomach that kind of drop again if you invested. If you can, then invest away.

 

If you are a little braver, then you can look at the lowest drop in the last 52 weeks, and if that drop is a drop you could stomach again, then take the risk and invest.

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