What is the right way to think about risk?
You see, most investors don't think about risk as it ought to be. Nor do they incorporate it appropriately in their investing decisions.
The most common approach to quantifying risk is to take standard deviation of returns. Some investors use coefficient of variation or sharpe ratio to measure risk.
Risk, in our view, is the likelihood of your desired level of capital not available when you need it. If you notice carefully, there are two very important considerations here:
"Desired level of capital": this is your best estimate of the amount of money that you need for a certain goal. Goal could be to send your kids to college, or buy a home or for your retirement. Implicitly embedded here is also the amount of return that you will have to generate in excess of a savings bank account investing in a money market fund.
"When you need it": this is your best estimate of the approximate time in the future when you will need the money, either in lump sum or when you will start taking withdrawals such as in retirement.
At Kuber.AI, we use two concepts to measure risk:
Sortino Ratio: mathematically, this metric does a good job at quantifying the downside risk of any investment relative to those of a safe money market savings account over the investing period. We like this over other risk metrics like standard deviation or coefficient of variation of returns or sharpe ratio for that matter, because it focuses on downside variations rather variations of both positive and negative returns. As such, it is better aligned with our view of risk
Probability of occurrence of certain magnitude of loss: Typically most investors can determine their future capital needs or "desired level of capital" needed with an accuracy of +/- 10-15%. So, we try to maximize average annual returns while minimizing the probability of a 15% year over year loss.
