Common sense investors are challenged to make sense of what is taught in business schools throughout North America as regards to Modern Portfolio Theory, particularly the use of standard deviation, beta, and the Sharpe Ratio for the measurement of risk. Regulators rely on measurements like these to categorize investments and then implement a system of risk management that is built up around these precisely wrong measurements for understanding risk. Risk isn’t nearly as neat and simple as it is made out to be using these mathematical formulas and historical pricing information.
As investors, we do not equate higher risk with higher returns because minimizing risk is what drives our returns. Understanding the difference between an investor and a speculator is a big differentiator where it concerns risk management. Just because someone buys a security it doesn’t necessarily make that person an investor. The same security bought for the same price by two people with different time horizons may be considered speculation if the intended holding period is too short. In the absence of understanding intrinsic value, anyone buying a security is speculating. Paying too much or not getting a margin of safety in the price of a security is speculating. The permanent loss of capital or a loss of purchasing power is a more apt description of risk where it concerns the objectives of most investors.
This white paper is written by academics, Eben Otuteye and Mohammad Siddiquee, who are challenging the long held beliefs of risk management and embracing the behavioral influences that are prevalent with decision making involving money. Unless you are Warren Buffett or Charlie Munger, it is difficult to challenge the establishment; having a contrary opinion invites agency risk. This is a well researched document that is pointing us in a much better direction. Enjoy!