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Market Sense and Nonsense: How the Markets Really Work (and How They Don't) by Joel Greenblatt, Jack D. Schwager

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Chapter 4

The Mismeasurement of Risk

Worse Than Nothing

More money has been lost through the mismeasurement of risk than by the failure to measure risk. It would be safer to drive a car without a speedometer than a speedometer that understated true speeds by 25 percent. If you had no mechanical gauge of speed, you would be conscious of that absence of information and take extra caution as a result. If, instead, you are relying on a speedometer you believe is providing correct readings but, in fact, is significantly understating actual speed, you will be more prone to an accident. Similarly, in trading and investment, relying on risk measurements that significantly understate true risk may be far more dangerous than not using any risk measurement at all. Indeed, many of the catastrophic losses suffered by investors have been a direct consequence of inaccurate risk measurement rather than the absence of risk measurement.

Perhaps the most spectacular example of how faulty risk measurement can lead to a drastically worse outcome than no risk measurement at all is the trillion-dollar-plus losses suffered by investors in 2007 and 2008 in debt securitizations linked to subprime mortgages, an episode detailed in Chapter 2. Investors bought these securities because the rating agencies assigned them AAA ratings—a risk evaluation that was based on assumptions that had no bearing to the underlying data (holdings that consisted entirely of unprecedentedly low-quality subprime mortgages). Imagine ...

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