Sunday, March 10, 2019

"Is semi-variance a more useful measure of downside risk than standard deviation?"

In Friday's "And Speaking of Black Goo: 'Norway’s $1tn wealth fund set to cut oil and gas stocks'" I included a story that touched on diversifying your investment risks away from the risks associated with your personal income-generating activities:
...A couple years ago I mentioned to a friend one guy's approach to dampening the sine wave of risk:
...During the dotcoms I knew a fund sub-adviser who would take his bonus checks and buy equity-indexed-annuities with a 3% annual guarantee, not to annuitize but for the accumulation.
He's probably beaten 90% of active managers over the last decade although I don't know if that would preserve real principal over the next ten years.

His specialty was biotechs and he wanted to reduce the semi-varience of his life....
Unfortunately the semi-variance link had rotted.
Here is the target the link was supposed to be aiming at.
From Dimensional Fund Advisors Fama (EFF)—French (KRF) Forum:

Is semi-variance a more useful measure of downside risk than standard deviation? My clients aren't worried about market surges, they're worried about market crashes.
EFF/KRF: In his classic 1959 book that defined modern portfolio theory, Markowitz considers the semi-variance as a potential measure of risk. Interest in the semi-variance fell by the wayside among academics because, at least for short holding periods (e.g., monthly), distributions of returns are rather symmetric. For symmetric distributions, the true variance and semi-variance are interchangeable, but because all the data are used to estimate the variance but only negative returns are used to estimate the semi-variance, estimates of variance are more accurate than estimates of semi-variance. For longer holding periods (e.g., a year or more), distributions of returns are right skewed, and no single measure of dispersion (e.g., the variance or the semi-variance) summarizes the overall risk of the distribution.

Let's now examine whether you really believe what you say about your client's tastes. In our (academic) terms, your statements imply that your clients are risk neutral on the upside but risk averse on the downside. If this is the case, the semi-variance, which ignores upside risk, is probably a better single measure of risk than the variance, but the conclusion is subject to the caveats above about the skewness of return distributions for longer return horizons....MORE
If yous see them together at some Chicago dive bar, Fama is the one with the Nobel around his neck, French the one saying "For Chrissakes Gene."

For more on semi-variance here's 2014's "The Equation that Will Change Finance"
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