Risk Management: Foundations for a Changing Financial World

CHAPTER 15

THE MISMEASUREMENT OF RISK^o

Mark Kritzman, CFA, and Don Rich

Investors typically measure risk as the probability of a given loss or the amount that can be lost with a given probability at the end of their investment horizons. This view of risk considers only the final result, but investors perceive (or should perceive) risk differently. They are affected by exposure to loss throughout the investment period, not just at its conclusion. We introduce two new ways of measuring risk—within-horizon probability of loss and continuous value at risk—that reveal that exposure to loss is substantially greater than investors normally assume.

In the long run, we are all dead. Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us that when the storm is long past, the ocean will be flat.

 

John Maynard Keynes A Tract on Monetary Reform (1923)

Investors typically measure risk as the probability of a given loss or the amount that can be lost with a given probability at the end of their investment horizon. This view of risk considers only the result at the end of the investment horizon, whether the horizon lasts for one day, one week, one year, or many years. It ignores what might happen along the way. We argue that exposure to loss throughout an investment horizon, not only at its conclusion, is important to investors. We introduce two new ways of measuring risk—within-horizon probability of loss and continuous value at risk (VAR). ...