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Trader Calabrese
The three myths of modern risk management
The three myths of modern risk management
Financial institutions in the post-crisis era have found themselves in two camps: those who have already spent an exorbitant amount of cash on state-of-the-art risk systems and those that are going to spend on the systems some time soon. And yet, investors and investment risk professionals have little confidence in the outcome of these efforts. The reason is simple: professionals with over a decade of experience have an intuitive and acute awareness of the three myths of modern risk management.
Myth number one: volatility is a measure of risk. All conventional risk management systems are built on volatility (or variance) as a measure of risk. Low volatility is always associated with low investment risk – this is a notion that is hardly ever questioned. However, there is plenty of evidence to suggest that our treatment of volatility as a measure of risk was in part responsible for the excessive risk taking in the period of 2005-2007. While the markets continued to appreciate in value, investors kept pouring more money into the same limited set of investments. In practice this meant that buying S&P 500 at 1100 was riskier than buying the same index at 1400. In fact, many institutions did not follow blindly their risk systems in that period, preferring instead to rely on common sense. They underutilized their risk budgets and were rewarded with lower draw downs.
Academic literature is also puzzled about variance as a risk measure. It is widely accepted now that the so called minimum variance portfolios tend to deliver higher returns with lower volatility. A simple strategy of buying only lower volatility stocks would yield a portfolio with lower volatility and higher returns. If we assume that volatility is a measure of risk, then we arrive at yet another counterintuitive conclusion: lower risk yields higher return. The truth is, volatility is a flawed measure of risk.
Although some may argue that best-in-class risk systems have abandoned normal distributions of returns and embraced the brave world of stochastic volatilities, jump diffusion processes and fat tail distributions, in practice this is a very little improvement, since all of these marginal improvements require key assumptions about volatilities.
Myth number two: correlation is a measure of diversification. The case against correlation (or correlation coefficient) is even more acute. Most investors by now have acknowledged that low correlations in calm market conditions exaggerate the benefits of diversification. The reason for this lies in the economics of systemic crises.
Consider a supply chain of automotive companies. Steel makers supply steel to car makers and in a normal economic environment the returns of steel stocks and automotive stocks may diverge based on relative negotiating power between the two groups of companies. Lower steel prices would be good news for the car makers. An investor holding both set of stocks would observe low return correlations. In a crisis environment, however, the whole supply chain struggles with lower volumes and all companies perform equally poorly. So just when the investor needs the benefits of diversification, the portfolio is faced with a single risky exposure.
Another problem with correlation is that different asset classes and assets have varying pace of news absorption. While correlation may be low if measured contemporaneously, the actual number may be much higher if different paces of news absorption are incorporated, which in practice is near impossible to estimate.
Myth number three: the underlying asset does not matter. This brings us to the most fundamental myth of the modern risk management – the belief that a full risk analysis can be carried out based on price series alone and with no knowledge of the specifics of the underlying asset. By buying a stock, an investor becomes a shareholder of a company. The investor runs the risk of mismanagement, adverse market for the company’s product, cost overruns, failed product introductions and a multitude of other quantifiable risks. The resulting volatility of the stock price is a mere reflection of true risks after the event. The risk of a major draw down, above all, depends on the price paid for an investment in the first place. All of the above, although intuitive from an experienced investor’s angle, is ignored by the modern risk management practice.
It is quite understandable then that despite all ongoing efforts to beef up the risk management function, experienced professionals are skeptical. All mainstream risk management systems are based on the three myths. They are useful in evaluating investment risks if everything goes well. And if not, then the experienced professionals will yet again be blamed for inadequate monitoring.
We have successfully applied an alternative risk management framework that is genuinely free from the myths of risk management. Graham Risk is named after Benjamin Graham, who first suggested a measure of risk based on the difference between the price and the intrinsic value of an asset. More about Graham Risk is available on GRAHAM RISK enabling viable alternatives
The three myths of modern risk management
Financial institutions in the post-crisis era have found themselves in two camps: those who have already spent an exorbitant amount of cash on state-of-the-art risk systems and those that are going to spend on the systems some time soon. And yet, investors and investment risk professionals have little confidence in the outcome of these efforts. The reason is simple: professionals with over a decade of experience have an intuitive and acute awareness of the three myths of modern risk management.
Myth number one: volatility is a measure of risk. All conventional risk management systems are built on volatility (or variance) as a measure of risk. Low volatility is always associated with low investment risk – this is a notion that is hardly ever questioned. However, there is plenty of evidence to suggest that our treatment of volatility as a measure of risk was in part responsible for the excessive risk taking in the period of 2005-2007. While the markets continued to appreciate in value, investors kept pouring more money into the same limited set of investments. In practice this meant that buying S&P 500 at 1100 was riskier than buying the same index at 1400. In fact, many institutions did not follow blindly their risk systems in that period, preferring instead to rely on common sense. They underutilized their risk budgets and were rewarded with lower draw downs.
Academic literature is also puzzled about variance as a risk measure. It is widely accepted now that the so called minimum variance portfolios tend to deliver higher returns with lower volatility. A simple strategy of buying only lower volatility stocks would yield a portfolio with lower volatility and higher returns. If we assume that volatility is a measure of risk, then we arrive at yet another counterintuitive conclusion: lower risk yields higher return. The truth is, volatility is a flawed measure of risk.
Although some may argue that best-in-class risk systems have abandoned normal distributions of returns and embraced the brave world of stochastic volatilities, jump diffusion processes and fat tail distributions, in practice this is a very little improvement, since all of these marginal improvements require key assumptions about volatilities.
Myth number two: correlation is a measure of diversification. The case against correlation (or correlation coefficient) is even more acute. Most investors by now have acknowledged that low correlations in calm market conditions exaggerate the benefits of diversification. The reason for this lies in the economics of systemic crises.
Consider a supply chain of automotive companies. Steel makers supply steel to car makers and in a normal economic environment the returns of steel stocks and automotive stocks may diverge based on relative negotiating power between the two groups of companies. Lower steel prices would be good news for the car makers. An investor holding both set of stocks would observe low return correlations. In a crisis environment, however, the whole supply chain struggles with lower volumes and all companies perform equally poorly. So just when the investor needs the benefits of diversification, the portfolio is faced with a single risky exposure.
Another problem with correlation is that different asset classes and assets have varying pace of news absorption. While correlation may be low if measured contemporaneously, the actual number may be much higher if different paces of news absorption are incorporated, which in practice is near impossible to estimate.
Myth number three: the underlying asset does not matter. This brings us to the most fundamental myth of the modern risk management – the belief that a full risk analysis can be carried out based on price series alone and with no knowledge of the specifics of the underlying asset. By buying a stock, an investor becomes a shareholder of a company. The investor runs the risk of mismanagement, adverse market for the company’s product, cost overruns, failed product introductions and a multitude of other quantifiable risks. The resulting volatility of the stock price is a mere reflection of true risks after the event. The risk of a major draw down, above all, depends on the price paid for an investment in the first place. All of the above, although intuitive from an experienced investor’s angle, is ignored by the modern risk management practice.
It is quite understandable then that despite all ongoing efforts to beef up the risk management function, experienced professionals are skeptical. All mainstream risk management systems are based on the three myths. They are useful in evaluating investment risks if everything goes well. And if not, then the experienced professionals will yet again be blamed for inadequate monitoring.
We have successfully applied an alternative risk management framework that is genuinely free from the myths of risk management. Graham Risk is named after Benjamin Graham, who first suggested a measure of risk based on the difference between the price and the intrinsic value of an asset. More about Graham Risk is available on GRAHAM RISK enabling viable alternatives
