Singapore-based financial blog that aims to educate people on personal finance, investments, retirement and their Central Provident Fund (CPF) matters.

Saturday, 17 September 2016

What we know about risk is all wrong

02:09 Posted by szcszc , No comments
The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment. Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. A high standard deviation indicates a high degree of risk.

Read more: Risk Definition | Investopedia http://www.investopedia.com/terms/r/risk.asp#ixzz3qE2I9SPs Follow us: Investopedia on Facebook

As you can see from the above, Investopedia defines clearly what risk is. Schools preach on what risk is, how it is calculated and how it is quantified. But after reading this book, I am questioning the method that we were taught.

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The book I am recommending today: The Most Important Thing: Uncommon Sense for the Thoughtful Investor by Howard Marks.

Honestly, from just skimming through the content page and back cover recommendations, this book looks like any other investment and finance book which "sells" you on conventional knowledge offered in many other books. However, what it presents is a wealth of knowledge that average investors do not note. An example of such is the following definition of risk, defined by the author himself, Howard Marks.



The diagram above shows the typical risk and return ratio that school generally preaches about, whereby higher risks should equate to higher returns and vice versa.

Image result for howard marks risk return graph
Credits: The Most Important Thing: Uncommon Sense for the Thoughtful Investor by Howard Marks


However, what Howard Marks came out with, was this diagram above. While the general theory of higher risks equates to higher returns, he adds in 1 more variable into this consideration. The higher the risks, the higher the median of each rate of return and the greater deviation of the possible rate of return.

This basically means the higher your risks, the higher the chances of your expected rate of return fluctuates.

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I came to realise the significance of this after taking a while to digest but I feel that it is something important to account for and not just taking unnecessary risks without accounting the consequences of it.

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