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Risk, Regimes, and Overconfidence

“It is customary to think of an investment&'s risk exposure in terms of its market value at the end of an investment horizon. But this essentially assumes that a serious loss, which develops during the holding period, will be ignored until the terminal date. A more relevant measure of risk exposure for an investor may be the probability that a loss of a given magnitude will develop at any time over the horizon. As Kritzman, Lowry, and Vanroyen show, these probabilities can be substantially larger than the point probabilities as of maturity day. A second property of the asset returns process that can induce incorrect risk assessments is the possibility that there are multiple regimes, e.g., calm periods and turbulent periods. Treating a historical sample of returns as if there were only one regime leads to underestimating exposure when one is in the turbulent period. This article presents useful and practical techniques for handling both of these problems, along with simulation results to show how much difference they can make in a practical setting.”