Definitions of Tractable Risk
The first step in discussing risk with a portfolio manager or investor is defining how it is going to be measured and calculated. The definitions need to be clear and understandable and specify what types of data are required to perform the calculations. This chapter outlines many of the ways risk can be measured and calculated and lays the foundation for several of the chapters to come.
THE EFFECT OF UNCERTAINTY ON OBJECTIVES
We would argue that risk is about uncertainty, but is not uncertainty. Consider a risk calculation as a methodology for calculating the risk of some event, but not whether the result of that calculation is meaningfully precise. That is, uncertainty isn’t about whether the calculation methodology is correct per se. Uncertainty is about our inability to calculate the risk accurately. Precision comes to mind in this regard. We may be quite accurate about how we are going to calculate a risk measure, but to what precision can we do this? This lack of precision is the uncertainty about an objective. Think of risk as the level you’re calculating and precision as how many decimal points out you can calculate this level to. Uncertainty defines the level of precision with which one can ascertain the risk. The greater the uncertainty, the lower the level of precision with which you can calculate the risk. ...