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Volatility - Not a good measure of risk
Risk is defined as volatility of returns where volatility indicates the unreliability of an investment. It is as a matter of convenience that volatility is considered as a proxy for risk, although it is not a comprehensive, sufficient and useful measure of risk.
Consider this: A stock that rises from Rs 50 to Rs 80 will have the same volatility as a stock that falls from Rs 80 to Rs 50. Can we say that the former is as risky as the latter? Similarly, a stock that rises from Rs 20 to Rs 80 linearly will be considered as low in risk, but if it declines to Rs 50 from Rs 80, it will be considered riskier. It is hard to think that a stock which is riskier at a lower price of Rs 50 than at a higher price of Rs 80.
To most investors, risk, first and foremost, is the likelihood of losing money. Risk is also subjective and personal, rather than intrinsic to the investment itself. Some of the popular ways of getting an idea about risk are as follows: Falling short of one's goal: Investors have differing needs, and for each investor the failure to meet those needs poses a risk. Falling short of the nest egg or amount required for a particular goal is one of the major risks an investor faces. This clearly implies that an investor has to be worried not only about the risk but also the returns, failing which he / she could face the risk of outliving his / her investments. The trade-off between risk and returns is the most intriguing and challenging job for most. It is an irony of investing that the rich can afford risks, but they don't need to, while the poor need to take risks, but they often can't afford to.
Underperformance benchmark risk:
You may be right in the short term but wrong in the long term and vice-versa. For outperformance in the long term, whether one can tolerate underperformance in the shorter term is the moot point.
There are two essential ingredients for profit in a declining market:
You have to have a view on intrinsic value and you have to hold that view strongly to be able to hang in and buy even as price declines suggest that you're wrong. The third ingredient is that you have to be right. Market recognizes whether you are right or wrong, not whether you are right for wrong reasons or wrong for right reasons.
Unconventionality: It is always comfortable to walk on the beaten and conventional track.
There is a saying: "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."
What is conventional and habitual, brings in lot of comfort while regret out of unconventional methods of investing is much more than that of conventional means.
Illiquidity:
Ability to convert your investment to cash at reasonable price at times when you require the funds determines the success of your investment. Absence of liquidity or conversion to cash at a huge impact cost would be major deterrent.
Finally, emotional reactions to risky situations often diverge from cognitive assessments of such risk. When such divergence occurs, emotional reactions drive behaviour. Behavioural biases fall into two broad categories: Cognitive and emotional, though both yield irrational decisions. Because cognitive biases stem from faulty reasoning, better information and advice can often correct them. Conversely , because emotional biases originate from impulsive feelings or intuition, rather than conscious reasoning, they are difficult to correct. Cognitive biases include heuristics, such as anchoring and adjustment, availability and representativeness biases. Other cognitive biases include selective memory and overconfidence. Emotional biases include regret, self-control, loss aversion, hindsight and denial.
Asset allocation is optimal if it suits the client's preferences and his / her risk taking ability so that the client holds onto his / her strategy over time. This strategy should be free from behavioural biases but it should take into account behavioural aspects of the client's preferences such loss aversion. A risk profiler has a questionnaire that assesses the client's risk taking ability, his / her risk awareness and his / her preference in a systematic way . The profiler also addresses the need for analysis, investment horizon, risk taking ability, aspiration level and the intensity for loss aversion.
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