I agree with you, but you still have not captured the risk. The uncertainty you mentioned is the uncertainty of the amount of reward (or more aptly oppurtunity cost). There is uncertainty, but that is the uncertainty in the amount of reward, which is still a concept of reward.
If I were to quantify the risk in the aforementioned scenario, I would ascertain what my limits are in terms of foregone compensation (for instance, do I have to make X amount in appreciation by Y date to be satisfied). Once this floor in identified, I would run through the various scenarios that these two securities could participate in. I ascertain what the worst case scenarios is (say the second security pays all of its appreciation on the last day of the year), then I ascertain the probability of this happening from historical data (or even the long term implied data as suggested by Chuzzlewit). So now I could say that I am 90% confident that the second security will pay 80% of its gains in the first 5 months of the year (limiting my oppurtunity loss to an acceptable level). This would make the risk figure 20% of the potential gain available at the last day of the year with a confidency level of 90%. Using a simple time value of money calculation, the first security is now more risky given its reward to me, the investor than the second security even though the second has more uncertainty to those that did not bother to perform a true risk analysis. This is also a reason why static volatility numbers will fail in a dynamic market. This is an illustration, so don't hold me to the numbers, I am just trying to show you how the larger institutions attempt to quantify risk when the traditional volatility measures allowed several consecutive meltdowns.
You see, in real life, risk and reward are much more than the up and down gyrations of a security. Although the calculations loosely illustrated above are based on volatility, they go much farther in quantifying the essence of what the investor fears - loss of capital, or more so in this scenario, oppurtunity cost. This concept comes awfully close to risk adjusted return, but that is the only scenario where risk truly means anything. |
