Understanding Risk

Model Risk

When you hire an investment adviser, your financial information and objectives will likely be fed into one or more models that provide asset allocation recommendations and indicate the risk and return parameters associated with each. In all probability, the adviser will then allocate your investments according to the model’s dictates. You shouldn’t go along with this without pausing for thought, because the assurance such models provide us is delusory. This isn’t just a problem of “garbage in, garbage out”–although I’ll come back to that in a minute. Because the models are mechanistic, they can’t properly reflect markets that evolve organically. […]

Risk and Uncertainty

Both in his brilliant book, Against the Gods, and in many of his must-read newsletters, the late Peter Bernstein warned against confusing risk and uncertainty. Risk lives openly in the distribution of probabilities that can be crudely estimated by statistical models. Uncertainty lurks in the wild. Like hurricanes, tornadoes, cyclones, earthquakes, tsunamis, and volcanos it may erupt suddenly, sometimes destroying everything in its path. Or it can abruptly sweep storm clouds away, revealing light and peace where we anticipated darkness and war. As investors, we can construct portfolios designed to survive most risks–even those heart-stopping bear market avalanches or the […]
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