They way we are taught to think about risk is wrong as this post illustrates in its MPT takedown. How about articulating ‘regret’?
In my experience, “Risk” is the single most misunderstood concept in finance. Volatility, risk and uncertainty are all terms that are used interchangeably on Wall Street. The confusion is in no small part due to the strong influence of “Modern Portfolio Theory”, which continues to live on despite the fact that it makes no sense. At the core of MPT is the (flawed) idea that risk is equivalent to price volatility. It’s remarkable to me that so much complex math has been built on the back of such a dumb assumption.
Risk = Volatility?
The willingness of the financial community to accept this assumption is astounding. Any reasonably intelligent person who stops to think about this for 5 minutes will realize how nonsensical it is:
- Volatility measures the extent to which a stock price has fluctuated historically, both upward and downward over an arbitrary time period (e.g. a month). Risk
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