Risk Aware Investing

Risk Aware Investing 2017-01-10T23:32:46-08:00

Risk aware investing means to weigh the potential rewards against the potential risk. One might use Sharpe ratios, information ratios, standard deviation, correlation, variance, or use non-quantitative strategies based on qualitative analysis.

The goal is to see if the potential reward is is big enough to justify the potential risk. The opposite of this strategy would be to simply chase after the highest returns without regard to potential risk which might temporarily lead to bigger gains but eventually the implied risk will catch up and hurt an investor who took on too much risk.

It is like the story of the tortoise and hare. The winner was the more cautious one.

Junk bonds, for example, actually produce a lower total return than lower yielding “A” paper because of losses to capital caused by defaults. Therefor risk aware investing shows that potentially the highest return in bonds would be from an investment that was not perceived as having the highest rate of return.

In the past decade various studies looking back 20 or 30 years have shown that some of the time stocks just barely beat the total return on bonds or vice versa, in other words the return was roughly similar, despite the fact that over a hundred years equities return more than stocks. What this implies is that the risk adjusted return of bonds is greater than stocks.

Of course, past patterns of behavior can change suddenly and unpredictably. One must constantly strive to examine hidden risk and then estimate the potential reward to see if the hare can really beat the tortoise.

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