Financial Advice for my Son (and JPL/CIT Employees)


Risk And Return

Definition of Risk

Any investment can be characterized by its riskiness. The definition is simple for anyone who understands a standard deviation, since "risk" in investment parlance is simply the standard deviation of returns from that investment!! There is all sort of confusion in financial literature because either the authors don't understand what a sigma is or because the authors assume that their audience does not understand what a sigma is! Be aware that Gaussian statistics do not hold - there is a tail at large sigma that significantly exceeds that expected from Gaussian statistics. For example, the 1929 and 1987 stock market crashes were each about a 10 sigma event, which would only happen once in the lifetime of the planet under Gaussian statistics!

Confusion also reigns because rarely do authors or salesmen tell you on what time scale is the sigma calculated.

Furthermore, even fewer people understand how to calculate the significance of any given number. For example, lists of "the best mutual funds over the last year" are virtually meaningless! That is, in general there is no significance to the fact that a given fund did better than another fund over the last year. The half of mutual funds that do better than the other half in a given year are just as likely to be in the bottom half in the next year as in the top half!!! (This is not to say all mutual funds are identical, see below.)

Because even so-called investment experts often don't understand the above, investment literature often closely resembles the fields of quackery (cancer cures) and dieting plans in the misinformation and wild schemes that are often presented.

If you have understood the last few paragraphs, you are immediately way ahead of at least 90% of the general public in the field of investing.

Return and risk

In general, if you want a higher return, you must accept more risk. This makes perfect sense: no one in their right mind would put their money in a riskier investment unless they expect to get a higher return. The extra return for a given level of risk is the "risk premium" that is necessary in order to induce investors to place their money in a riskier investment.

Go To:
Previous Page (Investing - Market Efficiency) : Next Page (Investing - Time Horizon)
Table of Contents

Go To:
Tom's homepage

e-mail: Tom Chester