Risk is a messy word as it carries so many different meanings in the investing world. In the most general sense, it means we don’t know what is going to happen. Here are several specific meanings of the term. We will begin by defining “systematic” and “specific” risk.
1. “Systematic” risk is risk we cannot avoid if we seek returns higher than the interest rates from a money market. This type of risk comes from inflation, interest rates, business decisions, foreign exchange rates, etc. This risk is the unknowns we face when entering the stock market.
2. “Specific” risk is the risk an investor takes over and beyond being involved in the stock market. If an investor chooses to invest 75% in technology and 25% in emerging markets, they are taking on a situation where the market may vary quite differently than their investments. Investors who select individual stocks take on additional “specific” risks and this varies greatly depending on the choice of stocks. To understand how sever the “specific” risk, one needs tools to make the measurement.
3. Risk Premium is the expected rate of return in excess of the risk-free interest rate that an investor demands to compensate for the risks inherent in an investment. The interest rate from a 90-day Treasury-bill is the standard risk-free interest rate. The Sharpe Ratio uses risk premium in the calculation.
Now we move into some common ideas of risk.
4. Committee members giving oversight to an endowment fund may define risk as follows. Will the endowment fund grow sufficiently to beat inflation, grow a little, and still be able to throw off 5% to fund their institution? That is asking a lot of a portfolio, but that is what endowment committees worry about.
5. The Common Person In The Street (T.C. PITS) thinks of risk as those days when the portfolio declines in value. Losing money is a risky endeavor and should be avoided. This comes under the specific definition of “systematic” risk.
6. The portfolio manager, and how I tend to used the term on this blog, thinks in terms of volatility. Most managers measure risk statistically by what we call standard deviation or mean-standard deviation. We feel there is a superior method to calculate volatility and it is semi-variance or semi-standard deviation.
Within the TLH spreadsheet (latest version) we have two ratios that include a risk component. Those ratios are known as the Sortino and Retirement Ratios.* In both cases, we use the semi-variance instead of the traditional mean-variance calculation to measure risk. The reason for using semi-variance is that we think it unfair to penalize a manager whose portfolio varies to the upside. After all, that is the desired goal. We only fuss about variation to the downside as we, like T.C. PITs, do not want to lose money.
* The Retirement Ratio was originally called the ITA Ratio.