In this session, I started with a definition of risk that includes both upside and downside, moved on to an intuitive derivation of the CAPM and its limitations, as well as why it still survives as the default. Towards the end of the session, I started on the first of the three inputs you need to get an expected return, the risk free rate.
Slides: http://www.stern.nyu.edu/
Definition Of Risk – Upsides And Downsides
Q4 hedge fund letters, conference, scoops etc
Transcript
And I'll explain in a minute what I mean by that. When you tell give me an answer what it does. What is a good working definition of risk you want to try. What is something that will affect your likelihood that you will get your money back. OK. Is that all you want to do is get your money back.
Because that seems like a pretty low threshold to meet. Right. Because not only when you invest Nordon and you see what I mean not only do you want to get your money back because principle protecting principle is important. But I think it's what you're saying. That's how you measure it. So let me not reframe what you're saying so you say.
So do you measure risk is danger to principle at all.
And do you expect that you don't have to change your answer just because I pushed you on it right. Because there is there is a value investing definition which is all about principle which is if my principle is protected then there's no risk. So that's not a bad definition. But if you want to protect returns to that's fine. Losing all your money if you lose 90 percent are you OK with that.
Why all your money.
OK so ratio between losing all your money what do you have to sell the other half of the ratio. OK. So basically you're measuring your upside return against the chance you will lose all your money.
Get. And the other definitions. Yes.
Oh come on you're looking at the next slide. No no no no no no. This is not right. But I'm glad you read it ahead of me so I'll come back and use my own definition on your.
Yeah your actual return is different from your expected return.
I'm going to put you under seal on this party would you be ok with your actual return is much higher than the expected return. You see where I'm pushing a bit. So you think that's risk to you. You as well. OK so now are your change going to add to the chance that you actually return would be lower than expected and is what do you worry about. What I'm trying to push you on is when I said do you think downside because that's where most of us think. And the reason I say finance classes ruined you for life is after you've spent a few sessions in a finance class. When asked what is risk and I'm glad that this answer you say standard deviation varies.
No human being thinks about risk in terms of standard deviation. Not even Nobel Prize winners in economics you know what risk is. It's that feeling in the pit of your stomach. Why are you sitting there watching the only stock you own meltdown and you can't get through your broker. That is a risk unless you felted you really have an asterisk. Risk is an abstraction that's why when you have an extended good market people can talk about risk but they really don't get. You need a crisis. A bear market to remind you that's why quarters like the last quarter of 2008 are good. You're saying what do you mean. Good. It was horrific. I lost 15 percent of my portfolio. That's good because it drew minds you of what risk is.
So I'm going to use that definition of it already used on me and talk a little bit about how I think the best definition of risk I've ever seen is actually the Chinese symbol for crisis. You know what. I've been corrected 50 times. I keep changing it and then somebody corrects me again or not. I don't know Chinese so I could let me be upfront about it this could be something obscene as far as I know. So I'm going to pretend I've been told that this is the Chinese symbol for crisis or big risk and it's a combination of two symbols.
Danger plus opportunity. To me it's a perfect definition of risk you know why. Because it connects the two and if you want one. You've got to live with the other. Who amongst us doesn't want opportunity we all want to make 70 percent returns right. But this is if you want to make 70 percent or don't be willing to live with a lot of danger or you don't like danger don't ask me for 70 percent returns. Think of how many mistakes in investing we would avoid if we remember this Every scath. At its heart. What does it offer. Whether it's Bernie Madoff or Ponzi it is. You can make a lot of upside. You can do a lot of opportunity with no danger and this is a reminder that that cannot be. To show you what happens when you lose that connection. Anybody from Orange County California. Don't worry I'm not going to pick on you. I like orange cardigan. You're from Orange County California. Great place to live sudden as always.
