02/06: Understanding Risk in Global Markets
In his 2004 book, Fooled by Randomness, (highly recommended), Nassim Nicholas Taleb provided one of the better analogies for market risk that I have encountered. See page 198 and 199 of his book.
Briefly he asks the reader to consider that what matters most is the confidence we have in any forecast. He uses the story of a traveller who has two options for a November trip. The first is a visit to Arizona and the daytime temperature estimate is 60 degrees with an expected variance of plus or minus ten degrees. The second option is a trip to Chicago with the same temperature estimate only with possible variation of 30 degrees!
The traveller can pack simply for the trip to Arizona because she has high confidence that the likely temperature will be between 50 and 70 degrees so light-weight clothing will suffice. The trip to Chicago involves much lower confidence in the temperature and requires planning for winter and summer as it may be 30 degrees or 90 degrees. Much more uncertainty (risk?) in the Chicago option.
Good description of variation, no?
As an investor in the US large-cap stock market you can expect returns over the next ten years of approximately 5.25% each year according to Benchmark estimates. But in any given year the likely range will vary from a low of -30% to a high of +40%. Our confidence level for any given year is quite low. Confidence rises over longer time periods but the consequences of big down years need to be considered. Risk must be managed.
Investing in large cap US satocks is much more like a November trip to Chicago.
OSF
June 2, 2006
Briefly he asks the reader to consider that what matters most is the confidence we have in any forecast. He uses the story of a traveller who has two options for a November trip. The first is a visit to Arizona and the daytime temperature estimate is 60 degrees with an expected variance of plus or minus ten degrees. The second option is a trip to Chicago with the same temperature estimate only with possible variation of 30 degrees!
The traveller can pack simply for the trip to Arizona because she has high confidence that the likely temperature will be between 50 and 70 degrees so light-weight clothing will suffice. The trip to Chicago involves much lower confidence in the temperature and requires planning for winter and summer as it may be 30 degrees or 90 degrees. Much more uncertainty (risk?) in the Chicago option.
Good description of variation, no?
As an investor in the US large-cap stock market you can expect returns over the next ten years of approximately 5.25% each year according to Benchmark estimates. But in any given year the likely range will vary from a low of -30% to a high of +40%. Our confidence level for any given year is quite low. Confidence rises over longer time periods but the consequences of big down years need to be considered. Risk must be managed.
Investing in large cap US satocks is much more like a November trip to Chicago.
OSF
June 2, 2006
