Five risks

Five risks are the five types of financial risk faced by long-term investors as opposed to those faced by short-term traders, who make frequent purchases and have shorter holding periods. Estimating the value of assets and portfolios may be enhanced by evaluating them through the lens of the five risks. Some of these risks are derived from traditional Modern Portfolio Theory concepts, but certain assumptions have been tweaked to provide a way of understanding how investments respond to various changes in the overall economy.
Market risk
Market risk has traditionally been measured through the beta coefficient of the Capital Asset Pricing Model. This coefficient represents the variability of asset (or portfolio) returns as they relate to the market (or some other benchmark). When market returns go up or down, beta indicates how much (and in which direction) the comparative asset returns tend to move up or down, based on historical values. Many investors use beta in their valuations of asset prices by calculating a risk premium that is higher for investments with higher betas—or greater risk.
Traditional calculations of beta do not distinguish between returns variability on days when the benchmark has positive returns and days when it has negative returns. This can lead investors to under- or over-estimate the risk involved with an investment when up-market and down-market variability are asymmetrical. An alternative measure, “downside beta,” has been proposed as a more precise way of measuring the real market risk investors face. Positive up-market returns variability indicates the “risk” of higher returns than the market on up-market days, which undermines traditional beta as a measure of financial risk for the rational investor. Because downside beta only measures returns variability on days when the market has negative returns, it is a more accurate proxy for risk. Furthermore, assets with high up-market returns variability and low downside beta (low market risk) are mistaken to be more risky by traditional beta measures.
Momentum risk
Momentum risk is a risk associated with a decline in the popularity of an asset (or industry, or asset class). While momentum-based strategies have been shown to be effective for up to six months, asset prices tend to revert to their economic values over longer time periods. One measure of momentum risk is a price-to-high-price trailing ratio that takes into account the market price and the trailing year’s high price. This value will always be between 0 and 1 because when a new high price is recorded, it becomes the new denominator in the ratio. This measure allows investors to eliminate from consideration assets that have fallen substantially in value in the last year, thereby mitigating momentum risk.
Intrinsic value risk
The intrinsic value of a stock relates to the company’s long-term cash-flow potential. Traditional measures of intrinsic value have been based on cash-flow analyses and investigations of financial statements which lead to forecasting that is subject to statistical error. These measures, however, do little to estimate the “systematic” or economic risk associated with asset value. To address this deficiency the Eta® model has been proposed as a more comprehensive proxy for intrinsic value risk. The Eta® model is an econometric model that explains, on average, over 90% of variance in asset prices. It measures how assets relate to the most influential 18 economic factors in the United States economy. Among these factors are the unemployment rate, bond yields, and the consumer price index. A good measure of intrinsic value risk within the Eta® model is the MacroRisk Index, which summarizes the absolute values of each of the economic factors’ impact on an investment’s price volatility.<ref name="Five Types of Risk" />
Residual risk
Investors also face risk that is not associated with general economic conditions. This is called the residual risk (also known as value at risk), and it is defined as the amount of asset value that remains unexplained by the general economy, based on a regression of the asset values and the Eta® model. The Residual Risk Index measures residual risk as a percentage of asset price.<ref name="Five Types of Risk" />
Attribution instability risk
The final type of financial risk that long-term investors face is attribution instability risk. This refers to the risk that an investment changes its relationship to the overall economy as measured by econometric models. <math>R^2</math> is a statistical measure of how well an econometric model fits the price data for a particular investment. Attribution instability risk is calculated as <math>1- R^2</math>, and it indicates the level of risk that an asset will not behave in a manner consistent with econometric predictions.<ref name="Five Types of Risk" />

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