Quantifying Risk: Volatility and Drawdown

Traditional financial theory has relied heavily on standard deviation or variance (the square of standard deviation) to quantify historic risk. Markowitz mean-variance optimization and the Sharpe ratio are two such examples under the umbrella of modern portfolio theory that reference variance or standard deviation as a proxy for risk in their formulation. However, there are some concerns with using these risk metrics that should be considered.

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The Most Important Thing

Investing consists of exactly one thing: dealing with the future.

-Howard Marks

Several years ago I was introduced to the writings of Howard Marks and have been a loyal follower ever since. The reflections he shares in his memos, while occasionally written from the perspective of a value investor, offer insights and reasoning that are applicable to many different fields of investing and life. I consider his memos to be essential reading, and The Most Important Thing acts as an excellent companion piece with additional thoughts and commentary. Below I’ve highlighted a few topics that I thought were worth a discussion

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Bulls, Bears and Beta

The Capital Asset Pricing Model implies that assets with high beta should provide a higher rate of return than those with low beta. High beta assets are such because of a high degree of market exposure: a large amount of correlation with the overall market and high volatility. But, is it possible that high beta assets, with their high volatility, may outperform during market booms and then underperform during times of distress (relative to low beta assets)?

I can’t take credit for this idea, but I thought it was an interesting thought and worth some exploration.

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The World is Flat (Sometimes)

Some of my favorite subjects in grade school were the accounts of famous global explorers such as Magellan and Columbus. The history of these pioneers usually has some attachment to the flat Earth theory–what was thought to be the prevailing thought during the middle ages. As it turns out this sentiment at the time was largely false as the ancient Greeks were among the first to theorize that the Earth was indeed spherical.

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Minsky’s Model of Mania

The word bubble, in the context of financial markets, gets thrown around a lot these days. Some of this is understandable considering the global economy was, and still is, recovering from the incredible recession of 2008-2009. Our senses have been heightened to watch out for what may be coming next. Regardless, the excessive usage begs the question: What defines a true bubble?

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