Measuring risk

Numbers and their limits.

Common measures

Standard deviation of returns, maximum drawdown, and ratios comparing return to volatility. Each summarises the past and none predicts the future.

Drawdown captures the lived experience better than volatility does.
Models built on normal distributions understate the frequency of extreme events.

Fat tails

Financial markets produce more extreme moves than a normal distribution implies. Risk models that ignore this look accurate for years and then fail at the worst moment.