Last night [April 2008], just when I wanted to close my eyes and go to sleep, my partner asked me how risky our investments are. As my dearest almost never asks about our investments I found this particular question and its timing quite bewildering. Bloody mass media and credit crunch. When it comes to our finances my clever, widely read, successful, gorgeous partner wants things explained in very simple terms. Most of the time she wants answers in a single word, one sentence at most. I know she wanted to hear “not risky” and despite that being my belief I could not give her that answer.

So what’s my problem with telling her what I believe to be true and what I know she wants to hear? My problem is I know she has a completely different view of risk than I do.

So today I spent all of ten minutes researching risk in the hope of crystallising my thinking. Google eagerly pointed me to the seminal paper on risk by the father of modern portfolio theory, Harry M. Markowitz’s Portfolio Selection.

Instinctively I had always assigned MPT and the association of volatility with risk as academic folly. In recent years I felt encouraged reading Buffett, among others, articulately illustrate the folly of volatility as a measure of risk.

Before reading Portfolio Selection I thought I’d take a couple online risk assessment tests. Taking these tests made me realise why I couldn’t tell my partner that our investments were not risky. Each test I took told me I was a “very high-risk investor”, while I believe I am a medium risk investor. Looking at the questions I realised they are framed with volatility and not value foremost in mind. It was then I realised that is the difference between my partner’s and my perception of risk. The classic opposing views of volatility and value.

I’m not sure if my loved one slept soundly or not after I closed our discussion by saying I’d welcome a massive market sell-off even if it meant our liquid net worth was halved.

For now I’ve decided to engage in some confirmation basis and re-read Buffett’s 1993 Shareholders letter prior to reading Markowitz’s Portfolio Selection.

After that I plan on determining my overall beta and applying anything I learn in Portfolio Selection. Then I’ll compare that with my combined margin of safety score that I regularly maintain. I doubt that will tell me much, but if I find I have a high beta then maybe I’ll look for more confirmation that it’s margin of safety that counts when thinking about risk. The last thing I want is to have years of positive market beating performance dismissed as mere beta. Actually the last thing I want is another colonoscopy, but both remind me of the same thing.

How do you define risk? Does anyone have risk a assessment questionnaire based on value rather than volatility?

I originbeatally wrote this in April 2008 and received many excellent replies including a link to The Mean Variance Optimization Puzzle: Security Portfolios and Food Portfolios (M Statman & K. Fisher) Financial Analysts Journal July-August 1997

Related posts:

1. Risk: Value vs Volatility
2. Taking Singles and Risk
3. Volatility Continues on the ASX and I’ve been Called
4. Volatility is Screaming
5. Surprise Volatility – The Option Sellers Worst Nightmare
6. Risk Reduction Strategies