What Is Risk? Lets start with your view Javier Go Estrada What - PDF document

Long ‐ Term Trends (II): Risk Javier Estrada ADFIN – Winter/2014 1. What Is Risk? • Your view • In the short term • In the long term • Evidence 2. Risk and the Holding Period • Evidence • Time diversification What Is Risk?  Let’s start with your view Javier Go Estrada  What is risk in the short term? IESE Go Business  Largely regardless of how risk is measured, stocks School Barcelona seem to be riskier than bonds in the short term Spain  What is risk in the long term? Go  Shortfall risk • P( R < Benchmark)  P( R < Inflation) → Buffett  P( R S < R B ) Go  Largely regardless of how risk is measured, stocks seem to be less risky than bonds in the long term ADFIN Winter/2014 1

Risk and the Holding Period  These two variables are critically intertwined Javier Go Estrada  Time diversification IESE Business • The longer is the holding period, the more likely is a School riskier (more volatile) asset to outperform a less risky Barcelona Spain (less volatile) asset  The longer is the holding period, the more likely is a higher exposure to risk to yield a higher return  Time diversification is a concept with critical and widely ‐ used implications  Financial advisors  Asset allocation informal rules • x B ≈ Age / x S = 100–Age Go • x B ≈ Age–20 / x S = 120–Age (More aggressive)  Largely consistent with the glidepath of TDFs ADFIN Winter/2014 So …  The bottom line (I) Javier Estrada  What is risk? IESE Business • Short‐term measures like … School Barcelona  volatility? Spain  spreads?  loses in worst‐case scenarios? • Long‐term measures like …  the probability of losing purchasing power?  the probability of underperforming a less volatile asset? • Is risk in the eyes of the beholder? ADFIN Winter/2014 2

So …  The bottom line (II) Javier Estrada  Relative to bonds, stocks have … IESE Business • in the short term, higher volatility School • in the long term, a very low shortfall probability (  2) Barcelona Spain  Then, why do stocks outperform bonds? • Is it a compensation for bearing short‐term volatility?  Are long‐term investors getting a free lunch at the expense of short‐term investors? • Is it myopic loss aversion ?  Loss aversion plus a short evaluation period  The evidence in terms of both data and the actions of practitioners is clear ADFIN Winter/2014 So …  The bottom line (III) Javier Estrada  Think and draw conclusions for your own investment IESE Business decisions School • How do (will) you evaluate the risk of your portfolio? Barcelona Spain • Should you be largely invested in stocks with little exposure to bonds? The other way around? A more balanced approach? • What trade‐offs are you willing to take? Go ADFIN Winter/2014 3

Appendix Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 What Is Risk?  You give me $100 to play a game Javier Estrada  Option 1 IESE Business • I give you back $105 School  Option 2: I spin a roulette … Barcelona Spain • If 0, you get $0 • If 1‐6, you get $107 • If 7‐12, you get $110 • If 13‐18, you get $113 • If 19‐24, you get $116 • If 25‐30, you get $119 • If 31‐36, you get $122  Which option is riskier? ADFIN Winter/2014 4

What Is Risk?  In terms of returns Javier Estrada  Option 1 IESE Business • R = 5% (Certain) School  Option 2 Barcelona Spain • If 0 → R = ‒100% ( P = 1/37) • If 1‐6 → R = 7% ( P = 6/37) • If 7‐12 → R = 10% ( P = 6/37) • If 13‐18 → R = 13% ( P = 6/37) • If 19‐24 → R = 16% ( P = 6/37) • If 25‐30 → R = 19% ( P = 6/37) • If 31‐36 → R = 22% ( P = 6/37)  Expected returns  O1: 5% / O2: 11.4%  Exactly as B & S in USA (1900‐2009) ADFIN Winter/2014 What Is Risk?  Which option do you consider riskier? Javier Estrada  G1 gives you $300 for sure IESE Business  G2 gives $100 per spot after rolling two dice School Barcelona Spain ADFIN Winter/2014 5

What Is Risk?  Note that … Javier Estrada  Option 1 has no uncertainty IESE Business  Option 2, in turn, … School Barcelona • has a very low shortfall probability Spain  P = 1/37 = 2.7% • has much more uncertainty  But it is mostly upside risk  Uncertainty about how much mor e, not how much less, you will have  So, what is risk?  Uncertainty?  Downside potential? ADFIN Winter/2014 What Is Risk? Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 6

Risk in the Short Term Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back Warren Buffett – Fortune (2012) Javier Estrada IESE Business School “Money-market funds, bonds, Barcelona mortgages, bank deposits … are Spain among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries.” ADFIN Winter/2014 7

Warren Buffett – Fortune (2012) Javier Estrada IESE Business School “The riskiness of an investment is not Barcelona measured by beta … but rather by the Spain probability … of that investment causing its owner a loss purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over the holding period.” ADFIN Winter/2014 Back Risk in the Long Term Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 8

Risk and the Holding Period Javier Estrada IESE RP<0 = 39/110 = 35% Business School Barcelona Spain ADFIN (*) 1900‐2009, S&P and 10Y Treasuries Winter/2014 Risk and the Holding Period Javier Estrada IESE RP<0 = 15/101 = 15% Business School Barcelona Spain ADFIN (*) 1900‐2009, S&P and 10Y Treasuries Winter/2014 9

Risk and the Holding Period Javier Estrada IESE RP<0 = 3/91 = 3% Business School Barcelona Spain ADFIN (*) 1900‐2009, S&P and 10Y Treasuries Winter/2014 Risk and the Holding Period Javier Estrada IESE RP<0 = 0/81 = 0% Business School Barcelona Spain ADFIN (*) 1900‐2009, S&P and 10Y Treasuries Winter/2014 10

Risk and the Holding Period Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back Risk and the Holding Period Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 11

Trade ‐ Offs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 12