Fortuna - Old and New Perspectives on Equity Risk Philip S....

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©2000, Association for Investment Management and Research 37 Old and New Perspectives on Equity Risk Philip S. Fortuna Managing Director Quantitative Group Scudder Kemper Investments lmost everyone would agree that accurate assessment of risk is critical for successful investment decision making. Despite all the work published on this issue, however, insufficient atten- tion has been paid to appropriately measuring, defin- ing, and assessing investment risk. As a result, the overwhelming majority of theoreticians, practitio- ners, and evaluators are using misspecified measures of investment risk, which has important implications for money managers and their clients. This presentation begins with a brief history of investment risk, going back to first principles. Next, I address some new criteria for thinking about risk, evaluate several proposed risk measures based on those criteria, and try to explain whether the type of risk measure used makes a difference. The final piece of the puzzle is applying these findings in a fund management setting. History of Investment Risk Most investment professionals have seen, if not pro- duced, reports that show the traditional risk–return scatterplot, in which risk is defined as the standard deviation of return. The typical reason for using stan- dard deviation is, in effect, custom: Standard devia- tion is what people learned to use, the method they use at their company, or simply the “right” way. When asked, practitioners really have no idea why it is an industry standard. So, an interesting starting point is how standard deviation became the accepted way of measuring risk. Harry Markowitz won a Nobel Prize for the work he did in the 1950s on portfolio selection. In his classic monograph Portfolio Selection , Markowitz laid out for academic economists how one should mea- sure risk and construct portfolios. He suggested four criteria for choosing a risk measure: cost of calcula- tion, convenience, familiarity, and quality of portfo- lios produced. Keep in mind that these criteria came from the perspective of someone in the 1950s who did not have access to today’s cheap computing power. Markowitz looked at a couple of definitions of risk and concluded that variance was the best risk measure to use because, compared with other mea- sures, it was cheaper (i.e., used less computer time), more convenient (i.e., the application of the formula was straightforward), and familiar to other financial economists. Other measures, however, produced bet- ter portfolios. Only under one condition were vari- ance-based portfolios as good as (not better than) those produced using another measure. We will return to this condition later. For Markowitz, using variance was a convenient
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This note was uploaded on 12/10/2011 for the course FNBU 3432 taught by Professor Yang during the Spring '10 term at Bentley.

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Fortuna - Old and New Perspectives on Equity Risk Philip S....

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