Investors typically think of risk as the uncertainty of wealth at the end of their investment horizon. By focusing on the dispersion of ending wealth, investors ignore the effect of interim losses, no matter how severe. Investors also measure risk as though returns come from a single regime, which may understate the likelihood and severity of interim losses.
The authors argue that the perception of risk as fully represented by the distribution of terminal wealth, together with the assumption of a single regime, leads to overconfidence. They apply first-passage probabilities to compare the risk of loss during an investment period with the risk of loss at the end of a horizon. Application of a methodology to measure risk based on quiet or turbulent regimes shows the extent to which the traditional measurement of risk understates exposure to loss.
The authors present a forecasting procedure to assess the relative likelihood of quiet and turbulent regimes, and show how to use this information to structure portfolios that are regime-sensitive.