RISK! What Risk?

Like a mirage, the more you look at financial risk the less sure you are about what you are really seeing. Risk is intuitively obvious. Or is it? You would think that with the long history of trading, risk would be really soundly understood. At one level it is; you have less money than you started with. But as you dig into the definitions and drill down you find at the end of the search - nothing! When I say 'nothing' what I really mean is you find a couple of competing definitions, not an absolute statement of pragmatic use about what risk is. Here is the best summary of our current understanding of the nature of risk I could find:

"A search of the financial literature yields many discussions of risk but few definitions. To understand risk, we must understand two streams flowing through the 20th century. One is subjective probability. The other is operationalism. Where they meet, we can understand risk."

Defining Risk, Glyn A Holton. Financial Analysts Journal. Nov-Dec 2004.

We can understand risk but we cannot define it. This looks a little like the situation before Newtonian mechanics came along. Scientists thought they knew on a case-by-case basis how the universe worked but until Newton famously got hit on the head by an apple while hiding in the countryside from the bubonic plague, nothing really tied events together. Later Einstein did the same for another bunch of 'facts' that proved a nuisance to understand.

Here is a bunch of risks that we can define, plus some. So if there is no fundamental way of quantifying risk are we left to assess it purely on a case-by-case basis?

We have found a way of expressing risk in a way the robot can use. Sufficiently general so as to cover a wide range of situations, but in no way a universal principle. Borrowing from many years experience in physical and IT security we don't think of trading as a financial assessment. In stead trading we assess as two asset classes experiencing particular threats. Each threat has one or more balancing countermeasures which can be activated under the right conditions.

Assessing how likely a perceived threat may occur in prevailing conditions indicates if we should activate the countermeasure. Risk, as an assessment of potential loss, is estimated by assessing how many unaddressed threats remain outstanding in the environment. The robot addresses two primary risks and juggles a balance between them. In ridiculously simple terms these boil down to:

First is the risk of not making a profit while out of the market. There is only one effective countermeasure, deciding to enter the market - but many ways of arriving at this conclusion. If after a risk assessment a countermeasure component fires, then it is most probably safe to enter the market.

Second, while in the market, should I now exit. Again, there is only one action to consider but if after a risk assessment a countermeasure fires it is wise to exit. However, if no countermeasure is triggered it is most probably safe to stay in the market.

The robot does not think about winning or losing. Many investors find this perspective hard to work with. It continually assesses its trading activity to figure out if its behaviour is in line with a winning strategy controlled by risk assessments. Individual transactions are almost irrelevant in its assessments. So long as it follows its risk assessment guidelines, overall it always wins. It plays with loaded dice.