What is Risk?

When we refer to risk in finance, we usually mean a form of standard deviation (SD) - volatility. As most investors would agree you would not mind a stock moving up once you are long or in other words as long as volatility is in your favour. Unfortunately this risk definition would not make any difference, if the market is moving up or down - once it is moving it is considered as risk.

All financial concepts you learn at your MBA, CFA, CIIA, CEFA Courses imply that the more risk the investor carries, the more risk-premium he will ask for. Whereby the risk-premium is usually defined as the risk-free rate + risk premium.

Since the financial crisis 2008 we see risk-free rates yielding Zero return or contribute even negative to the portfolio return (like Germany).

This is challenging for investors who used to manage a decent return over many years by holding bonds and investing modest on the stock-market. The backbone of there asset-allocation (core-strategy) is returning almost nothing and after management fees they are left with a negative return.

Capital is slowly but steadily melting!

What to do?

It is certainly much more challenging nowadays to earn a premium ontop of your  Management Fees - or in other words - add value to your investors.

Voices are already talking about a lost decade (pointing towards Japan) and this are the optimists.

Besides the fact that the risk-free rate is not always risk-free and misleading as the default risk of a country does always exist, irrespective if you control and run a central bank. Clearly the volatility of the bonds have been pretty dramatic during the 2009 - 2011 period.

So, if we use volatility as risk measurement a so called risk-free rate bears a considerable high volatility, especially on the long end. Just look at the iShares ETF (IBCL.DE - yahoo).

Just a final remark the observed historical volatility - using SD - neglects tail events - events which might not have occured during your observation period - hence I'm not using it to measure the risks in my Portfolio.

During backtesting I calculate the maximum Drawdown of the System and this gives an initial indication if the system pleases my modest risk appetite or is a bit to risky.

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