Investment Risk and its 3 Tenses
Past, Present and Future.
I often ask investors to ‘describe the highest risk position they own’. Most responses I get, centre on what they believe ‘will or might’ occur. So risk is commonly associated with things that haven’t actually happened. The future tense.
The asset management industry and specifically risk departments, love the ‘rear view mirror’ when pondering risk but, the same industry constantly reminds us - ‘past performance is not necessarily a guide to the future’.
To me however, the most under-appreciated tense in an investment process and the wider industry is the present. Let me expand this idea…..
Einstein said “Logic will get you from A to B. Imagination will take you everywhere.” Most investment risk discussions are logical but not very imaginative. Here is a more imaginative formula to express an investment risk framework:
Risk = Understand Historical Data + Clarify Current Risk Rules + Estimate Future Events
The Past (historical data)- the industry tends to be somewhat lazily focused on a simplistic, backward looking measure - volatility. The calculation of volatility makes some assumptions: returns are normally distributed and correlations are stable. I’m no quant, but neither seems to be consistently valid. Understanding historic volatility data gives some information about dispersion of returns but is very incomplete as a measure of risk.
Memory is a process with one input being the truth and many PMs use memory to understand their historical decisions. Far from ideal.
More preferable would be historical data analytics which rely more on facts than beliefs. Excellent analytical software exists (both in house and through a small list of external providers) that is designed to root out interesting patterns. However, data analytics alone, without what you knew at the time of the decision and how you weighted components of this knowledge, is far from optimal. These historic patterns might exist but simply be ‘dumb’ correlations. Only by adding behavioural input at the time the decision is made, can we understand possible causation behind the analytics.
The Future (future events)- the American economist Ken Galbraith put it perfectly when he quoted:
’ there are 2 kinds of forecasters, those who don’t know and those who don’t know they don’t know’
From my experience there are more than a few macro strategists who have made their career reputation from being right once in a row!!
Perhaps even combining some useful historical data, with machine learning, AI and statistics might assist with prediction but it’s worth noting that predictive analytics is in its early days.
The point is, future events are tough to see coming and anything that might occur to change the outcome of an investment is called risk. It’s something that may or may not happen …but if it does, it will force you to do something in the present.
The Present (current risk rules)- having clear, current risk rules in any investment process is fundamental and something an investor controls. However, it frequently surprises me how many PMs are not at all clear on their current risk rules.
Understanding these risk rules means that as an investor, you have to understand your natural risk disposition.
What illustrates an individuals risk disposition? Allow me to share with you a lesson I remember during my first month of a graduate trainee program in New York in the late 80’s. One memorable afternoon, the hard-nosed MD offered us a proposition - he’d pay 2:1 odds on a single flip of a coin. He asked one of us for a quarter (in case we thought his was a dodgy coin!) and offered each of us in turn the chance to wager between $1 and $1,000 on a single coin toss ….call it right and we would double our bet, get it wrong and he’d keep the cash.
The range of bets risked from the 12 of us was interesting in its variance!! Whilst it might have had something to do with our relative wealth ….the lesson was, that the individuals risking $500 plus had the likely higher natural risk disposition as investors!! (I risked $50 and lost !:-))
Objective risk assessment is also loved in the world of finance. An “objective” risk is independent of the observer and therefore measurable. It does not vary from observer to observer….The 2:1 odds on the coin toss for example. Conversely, a “subjective” risk assessment is one that depends on something innate and unique to the observer. Incidentally- a very reliable subjective risk psychometric assessment is now available as an on-line assessment.
Subjective risk assessment is neglected by the investment industry as is clarity on current risk rules. In my opinion, both are part of the vital present tense.