You are looking for a London hotel room on the Internet. You find the same hotel room at two different sites (both including taxes) at two different prices:
Which is the better deal? The answer may seem obvious, but it’s not. On one occasion, when I posed this question to a conference audience, one attendee shouted the response, “It depends whether they both include breakfast.” “That would have to be a very expensive breakfast,” I answered. But at least he had the right idea. The question I posed contained incomplete information. I didn’t specify what currency the prices were quoted in. What if the 320 price was in dollars and the 250 price was in pounds? Changes everything, doesn’t it?
“Well,” you are probably thinking, “no rational person will ignore the currency denomination in comparing two prices, so what’s the point?” The point is that investors make this type of error all the time when selecting investments by focusing only on returns. Comparing returns without risk is as meaningless as comparing international hotel prices without the currency denomination. Risk is the denomination of return.1
Consider the two managers in Table 8.1. Which is the better-performing manager? We assume that hidden risk, as discussed in Chapter 4, is not an issue and that standard deviation is therefore a reasonable proxy for risk. We also assume that the managers are considered qualitatively ...