Black Swans

This post was a response to a student's post about risk.

Black Swans

Well done. Assessing risk can be very complicated. Business or financial risk is normally seen as the degree to which the actual return might vary from the expected return. This is assumed to fall within a bell curve distribution from the expected return. The term volatility is often used. For example, the volatility of a particular stock is one standard deviation from the average return of that stock. The greater the volatility, the riskier the stock. http://www.investopedia.com/articles/04/021804.asp

Another related measure of risk is referred to as Beta. Beta compares the historical movement of an investment to the market as a whole. A Beta of 1 tells you that the investment moves exactly the same as the market. If the market were to increase 10%, you would expect the investment to increase 10%. For example, GE has a Beta close to 1. http://finance.google.com/finance?q=NYSE:GE A Beta more than 1 indicates that an investment tends to swing more widely than the market as a whole. Oracle Corp. is an example. Its Beta is 1.78. http://finance.google.com/finance?q=NASDAQ:ORCL An unusual example is Apollo Group (owner of University of Phoenix). It has a negative Beta, meaning it tends to more opposite the market to some degree. http://finance.google.com/finance?q=NASDAQ:APOL

Notice, that these types of risks are based on historic numbers. They do not tell you much about how things might be different in the future. There are always things that are unexpected of unanticipated. For example, the people at Dubai Ports World probably were very good at calculating the above type risk associated with buying pert terminals in the US. I am sure they checked the data and saw the performance of the terminals in the past. They probably considered the effect of combining those operations with their other operations. But, what they missed was the media frenzy and the misunderstandings that would develop over the deal. It was misreported that the company was buying the entire ports (not just certain terminals in ports). Of course there were all kinds of exaggerated stories about this Al Qaeda member or that spending time in UAE, like that somehow tied DPW to terrorism, etc. This is a different and very difficult type of risk. It is based largely on the unknown. Since we do not know what we do not know, these types of events are referred to as Black Swans. (Everyone thought all Swans were white for hundreds of years until someone discovered black swans in Australia). http://en.wikipedia.org/wiki/Black_swan_theory

As we move through the class, keep these concepts in mind. It is important that business people learn to deal with risk (as much as possible).

		September 18, 2007 *Risk and Black Swans*
	This post was a response to a student's post about risk. Black Swans Well done. Assessing risk can be very complicated. Business or financial risk is normally seen as the degree to which the actual return might vary from the expected return. This is assumed to fall within a bell curve distribution from the expected return. The term volatility is often used. For example, the volatility of a particular stock is one standard deviation from the average return of that stock. The greater the volatility, the riskier the stock. http://www.investopedia.com/articles/04/021804.asp Another related measure of risk is referred to as Beta. Beta compares the historical movement of an investment to the market as a whole. A Beta of 1 tells you that the investment moves exactly the same as the market. If the market were to increase 10%, you would expect the investment to increase 10%. For example, GE has a Beta close to 1. http://finance.google.com/finance?q=NYSE:GE A Beta more than 1 indicates that an investment tends to swing more widely than the market as a whole. Oracle Corp. is an example. Its Beta is 1.78. http://finance.google.com/finance?q=NASDAQ:ORCL An unusual example is Apollo Group (owner of University of Phoenix). It has a negative Beta, meaning it tends to more opposite the market to some degree. http://finance.google.com/finance?q=NASDAQ:APOL Notice, that these types of risks are based on historic numbers. They do not tell you much about how things might be different in the future. There are always things that are unexpected of unanticipated. For example, the people at Dubai Ports World probably were very good at calculating the above type risk associated with buying pert terminals in the US. I am sure they checked the data and saw the performance of the terminals in the past. They probably considered the effect of combining those operations with their other operations. But, what they missed was the media frenzy and the misunderstandings that would develop over the deal. It was misreported that the company was buying the entire ports (not just certain terminals in ports). Of course there were all kinds of exaggerated stories about this Al Qaeda member or that spending time in UAE, like that somehow tied DPW to terrorism, etc. This is a different and very difficult type of risk. It is based largely on the unknown. Since we do not know what we do not know, these types of events are referred to as Black Swans. (Everyone thought all Swans were white for hundreds of years until someone discovered black swans in Australia). http://en.wikipedia.org/wiki/Black_swan_theory As we move through the class, keep these concepts in mind. It is important that business people learn to deal with risk (as much as possible).