Risk Management Revisited

by Duncan Hughes

Executive Summary
Traditional risk management techniques have failed the asset management industry in recent years as portfolios have been unable to deliver sustainable returns throughout the economic cycle. The world, and consequently the factors affecting investment portfolios, has shown itself to be more complex and therefore less predictable than has been assumed to date, and particularly with regard to the impact of human behavior on investment returns. The requirement for contingency planning for risks that we cannot know about ex ante requires a sea change in the industrys approach to risk management. Effective liquidity planning and protection of portfolios against clear secular risks, such as inflation, must form a core part of a robust risk management approach.

Introduction
Risk management has taken centre stage in many commercial organizations in recent years, but it is in the financial services industry that it has assumed the greatest prominence, particularly since the subprime crisis and the ensuing credit crunch of the late noughties. Major banks and asset management firms now boast a chief risk officer (CRO) sitting alongside the chief financial officer (CFO) and other executives on the main board. While this innovation could be viewed as rather shutting the stable door after the horse has bolted, it nonetheless demonstrates a renewed commitment to risk management, which has traditionally been viewed as a synonym for business prevention. This previous sentiment was clearly demonstrated in an infamous incident involving the then CEO of the Halifax Bank of Scotland Group (HBOS)who was also the deputy chairman of the United Kingdoms Financial Services Authority (FSA) before he was forced to resignwho fired the groups risk manager at the height of the subprime boom in 2005 for challenging the banks cavalier approach to risk management.
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The focus on overhauling risk management in financial services gained considerable impetus from the publication of official critical reviews, such as the Turner Review by the FSA, which, although primarily concentrating on the banking sector, nonetheless calls into question the fundamental tenets on which risk analysis in the asset management industry have been traditionally based. While those of us who have lived through a series of greed/fear cycles in financial markets over the last 25 years or so may be forgiven for cynically anticipating that any new prudent risk management measures will quickly be discarded if and when markets begin to rally, it is likely that the subprime crisis and its aftermath will result in a lasting philosophical change in the risk management paradigms employed by asset managers. The statistically convenient and mathematically elegant models previously used in risk modeling must give way to more heuristic and empirically effective approaches to analysis that reflect the realities of the world of investment and are better able to allow for the idiosyncratic and, at least partially, stochastic behavior of financial markets. Economics is a social, not a pure, science, unlike pure mathematics or physics, and consequently cannot be modeled in the same way. The effect of collective human behavior that influences all economic indicators is exacerbated in financial markets, which are more strongly and immediately influenced by the emotions of greed and fear. Any analysis of risk that does not encompass the impact of human behavior in financial markets (or behavioral finance as it is generally called) is probably dangerously incomplete.
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The Traditional Approach to Risk ManagementA Critique

Underlying Statistical Framework
The basic tenets underlying the risk management policies and techniques that are generally employed in financial markets make perfect theoretical sense. Risk is usually equated to volatility, the idea being that the greater the variance an investment exhibits from an expected or mean return, the greater is its risk. Similarly, the idea of portfolio diversification resonates with most of us given our mothers advice not to put all our eggs in one basket. Although the mathematics and statistical techniques required for optimal portfolio construction look impressively complex, it has become clear that these techniques, and the models on which they are based, have been ineffective in protecting investors from the risks that they faced. The devil, as ever, is in the detail. In order to get to the root of the problem, we must first critically evaluate the statistical models that underlie risk analysis. First, let us examine the measure of volatility that is generally used, i.e. standard deviation. Standard deviation purports to provide us with a measure of how much a variablefor our purposes, the value of an investmentwill vary from its mean, or expected, value, . From standard deviation, , we can readily calculate confidence intervals, which are a measure of the probability of the actual outcome falling within a given tolerance of the expected value. Thus, for a risk tolerance of one standard deviation, we are confident that the actual outcome will fall within the given range 68% of the time. If we have less risk tolerance, we might insist that the actual outcomes fall within a given range 95% or 99% of the time (roughly corresponding to two and three standard deviations, respectively; see Figure 1). So far, so good: we can prescribe the level of risk that we want to assume and select investments that meet the required statistical criteria.

Figure 1. Standard Normal distribution and 95% confidence interval The problem is, however, that standard deviation does not at all adequately describe the possible actual outcomes of financial markets. Technically, standard deviation is the second moment of a probability density function (where the mean, or expected, return is the first moment). There are, however, two further moments of probability density functions (moments could be seen as being analogous to the four dimensions of space and time), these being skewness and kurtosis (Figures 2 and 3).

Figure 2. Third moment: skewness

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Figure 3. Fourth moment: kurtosis Different financial markets exhibit different, but not generally neutral, levels of skewness and kurtosis. Most notably, many financial markets have probability density functions with fat tails (technically, leptokurtosis). Crucially, this implies that financial markets have many more extreme outcomes than that predicted by the use of standard deviation alone and the underlying assumption of the normal distribution that a two-moment model dictates (indeed the normal distribution is expressed in statistical shorthand as N(, ) where represents the distributions mean, expected value, and represents its standard deviation). Some markets tend to exhibit skewness, where either more of the actual observed outcomes fall above (positive skewness) or below (negative skewness) the expected return. A notable example of this phenomenon is senior credit instruments, which deliver an actual return that is more often higher than the expected return due to their generally extremely low incidence of default. The key here is that the use of standard deviation alone has the hidden assumption of zero skewness and neutral kurtosis (technically, mesokurtosis) in the expected distribution of actual returns. If we now turn to the question of portfolio diversification, the key underlying statistic here is correlation, which is the degree to which one variable, or investment for our purposes, moves in line with another investment. In forming a portfolio, optimization techniques minimize the degree of intra-portfolio correlation given the constraint of a given number of investments. Modern portfolio theory tells us that we should have as many different investments in our portfolio as possible, since each additional investment will increase the robustness of the portfolio through increased diversification. The apogee, according to modern portfolio theory, is the market portfolio, which contains every conceivable asset, since we should seek to squeeze every last drop of correlation benefit from the available asset pool. X,Y = cov(X,Y) XY This states that the correlation of investments X and Y is the quotient of the covariance between the returns of X and Y over the sum of the standard deviations of X and Y individually. From this formula we can once again see the specter of standard deviation at the feast. As before, this condemns the correlation coefficient, , to being a two-dimensional (or, strictly, two-moment) measure, ignoring the real-life facets of skewness and kurtosis in investment returns. The implication is that the benefits hoped for from diversification may be severely undermined. None of the above is beyond the grasp of most market practitioners (skewness is, after all, nothing more than a description of the position of the mode relative to the mean in a probability function), so the question is, why have financial markets persisted with the use of these models, particularly when they have consistently proved themselves to be inadequate? The answer may lie in the sheer convenience of standard deviation-based measures: everyone can understand the idea of standard deviation and the confidence intervals that can be derived from the normal distribution which it describes. However, the fact remains that models which stop at the second moment of standard deviation, ignoring the third and fourth moments of skewness and kurtosis, are as limited as a description of our physical world would be if we tried to describe it using only length and breadth and ignored the dimensions of height and time. Although it is unclear what should replace this framework in the analysis of financial markets (and it clearly needs to be replaced), it is nonetheless imperative that the assumptions described above, which implicitly underlie any analysis carried out using it, must be recognized. The overreliance and overconfidence in these models has, I believe, been a significant factor in the general empirically disappointing performance of asset portfolios, particularly in their inability to weather the all-too-frequent financial storms to which they are subjected.
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Information and Other Issues

In addition to the inappropriateness of the statistical models on which investment analysis has been based to date, the received wisdom of risk management has also included other flaws and oversimplifications. One clear, and frankly gross, oversimplification is the assumption that risk is somehow homogenous and that, for example, equity investments relating to firms in Argentina or Sri Lanka can be analyzed using the same type of framework as for those stocks included in the S&P 500 index of the largest publicly quoted firms in the United States. One of the principal reasons why this approach is asinine is that the cohort of investors
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interested in various securities markets are different, both in their behavior and in their investment horizons and objectives. Similarly, the use of standardized techniques for the analysis of alternative investments such as private equity and hedge funds is fatuous at best, but more likely extremely dangerous. Other issues include myopia, which has been proposed as an explanation for the historical outperformance of equities over bonds, but which more generally manifests itself in a lack of focus on the big picture. Asset managers are overwhelmed by information presented to them 24/7 by a plethora of sources such as CNN, Bloomberg News, broker research, and daily newspapers. This information overload can dangerously obscure the secular themes which generally represent the greatest knowable (and therefore manageable) risks to an asset portfolio over the intended investment horizon. Depending on a particular portfolios objectives, these themes might include those shown in Table 1. Table 1. Secular themes as sources of long-term portfolio risk Secular Theme Aging of G7 population Polarization of wealth Domination of big oil Global population explosion Globalization Environmental concern Implication Lower demand for equities Lower consumer spending Higher oil prices Food shortages Greater competition Higher cost of doing business Risk Equity markets become moribund Economic growth falters Inflation Inflation Reduction of lives of businesses Inflation Lower equity returns
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New Directions in Risk Management

Decomposition of Risk
A first step in the robust analysis of the risk of an investment is to break down the risks into sensible (and honest) categories. Particularly in the ambit of asset managementwhere investments are considered within the context of an overall portfolio, and an important consequent dynamic is their behavior with respect to the other constituentshomogeneous factors (such as the securities market and liquidity) need to be separately identified from heterogeneous factors (such as branding and management). As will be discussed subsequently, we also need to build in tolerance for those risk factors that cannot be known at a given point in time, but which may become important or dominant.

Behavioral Finance
From an academic perspective, the worlds of psychology and financial economics definitively came together in a meaningful way in 1979 with the publication of Kahneman and Tverskys seminal paper on prospect theory, which introduced empirical evidence that a subjects attitude to loss is very different to that toward a similar gain (essentially, that subjects felt a loss considerably more than they felt a gain). This contradicts the standard utility theory assumption that underlies expected behavior in microeconomics and it is therefore an important refinement. This differential is illustrated by the asymmetric value function shown in Figure 4.
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Figure 4. An asymmetric value function To emphasize the point, the value function relating to financial markets differs from the utility function that is generally used in microeconomics in two ways: first, the function is asymmetric, i.e. the behavior exhibited with regard to a gain (being risk-aversion, i.e. preferring a definite gain) is different to that exhibited for a loss (being loss-aversion, i.e. preferring to take risk to avoid a loss). Second, the value function described above illustrates far more extreme reactions to losses or gains than that exhibited by standard utility functionsparticularly with regard to losses, where there is no tolerance for a small loss and experiments have shown that subjects will risk suffering a significantly larger loss to avoid a definite smaller loss. Further groundbreaking empirical research was carried out by De Bondt and Thaler in 1985, which clearly demonstrated that investors and traders overreact to both good and bad news. Bringing these discoveries back to our probability distributions from the first section, we can see a psychological rationale for the missing third and fourth moments of the probability distribution observed in financial markets. These are shown in Figure 5.
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Figure 5. Behavioral impact on market returns profile Behavioral finance is a burgeoning field and deserves fuller treatment than that provided here. Table 3 provides a brief summary of some important concepts that go beyond the familiar greed and fear paradigm. Table 3. Major theoretical frameworks in behavioral finance Theory Prospect theory Concept Implication

Subjects have a different approach Negative skewing of investment to managing gains than to return profile managing losses Subjects react inconsistently with standard utility theory when presented with option of certainty Overvaluation of certainty with respect to standard utility theory
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Allais paradox

Risk Management Revisited

Framing

Subjects make different decisions with regard to the same choice depending how the choices are framed Subjects base their investment decisions on a fixed reference point, e.g. a previous valuation of a property Subjects avoid selling stocks to crystallize a loss Exaggeration of probability of success Individual investors compartmentalize their portfolios into a risk-averse part and a risk-seeking part. Particularly important where investors have already made (large) gains, q.v. Brian Hunter at Amaranth.
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Unpredictability of investor behavior because dependent on each subjects (different) perspective Unpredictability of investor behavior because dependent on each subjects (different) reference point Negative skewing of investment return profile Positive skewing of investment return profile Difficult to predict overall investor behavior because dependent on the compartmentalization approach of each

Anchoring

Regret theory Wishful thinking bias Mental compartments

Representativeness heuristic

Subjects see patterns in random data (e.g. head and shoulders, etc.) Subjects inability to make a decision without historical information

Groups of market participants herd into positions when they see these patterns, distorting market returns Overreliance on historical data

Disjunction effect

In summary, these phenomena cannot be ignored when considering the behavior of financial markets. A logical consequence of all of these differing, and often conflicting, individual behaviors is that the aggregate behavior of the market may well just be too complex to model at all accurately. For an interesting (and more complete) treatment of behavioral finance, see Shiller (2004).
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Epistemology
Although all aspects of epistemologybroadly speaking the study of knowledge and the justification of beliefsare of interest (particularly when considered in conjunction with the psychological phenomena discussed above), from the perspective of financial markets it is the scope and limitations of knowledge that are of most interest. The key issue is that there are events that will occur in the future that we cannot know about now. These black swans, as Nassim Taleb famously describes them, can be as devastating as they are unpredictable. From the perspective of our models of potential outcomes, the most important facets of this phenomenon are as follows. The incidence of extreme, unpredictable outcomes is far higher than forecast by the normal distribution of returns described above (some of the dramatic events in a short period in 201011 are listed below). Thus, the probability density function that we face is more leptokurtic, i.e. has fatter tails. Empirically, more unanticipated bad events are reported than goode.g. natural and anthropic disasters. The probability of these events is rarely, if ever, factored into asset prices and risk models, despite their frequency and consequential impact.
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The limitations of knowledge extend not only to what we can know, because situations are too difficult to model and, therefore, to predict (e.g. climate change, the Russian crop fires of 2010, the devastation of Queensland in late 2010/early 2011, the causes and effects of the strife in the Arab world in early 2011, the
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Christchurch earthquake of February 2011, and the Japanese earthquake and ensuing tsunami of March 2011). They also affect us at the micro level, in terms of what we are not told: even the largest shareholders in publicly quoted companies can only see through a glass darkly into the machinations of corporations through the dimly lit and narrow apertures of shareholders meetings and infrequent meetings with senior managers. From this perspective, private equity investment is actually less risky, or at least less opaque, since investors usually insist on having a seat on the board of the company in question. The overwhelming point is that we think that we know more about the future than we actually dothat is, we are consistently overconfident in our predictions of the future and systematically underestimate what can go wrong and by how much it can go wrong.

Case Study
Toyota Motor Corporation
In the analysis of any individual investment, the main challenge for asset managers is to establish an effective paradigm for risk analysis. Whilst some risks will be specific to the company or issuing entity to which a security relates, others will be extraneous to it, and may be common to a number of assets in a portfolio. Table 2. Examples of risks faced by investors in Toyota Factor Automobile manufacture Example Risks Oil price increase reduces demand Subject to discretionary spending by consumers Low-cost competition Share price falls along with Japanese/global market Lower demand from aging population Strong brand undermined by accelerator pedal issues Traditional Japanese management structure and philosophy could make firm vulnerable to competition from firms that outsource manufacturing

Japanese equity Brand Management

A key point here is that, even in this simple analysis, there is a lot of uncertainty. Although we know that sales of Toyota cars will probably fall if the oil price rises, standard supply and demand analysis may be inadequate and actual demand may well be subject to critical thresholds (e.g. oil at US$200 per barrel, or where it costs a US consumer $100 to fill his or her Toyota with gasoline) as well as other factors. The accelerator pedal issues faced in 2009, which tarnished Toyotas previously premium brand, could not have been known by asset managers who invested in 2008. The risk faced by investors is broadened purely through the membership of Toyota in the Nikkei 225 index, which is a proxy for the Japanese equity market and, more generally, the Japanese economy. Consequently, a natural disaster, such as the earthquake and tsunami of March 2011, that affects Japan will adversely affect an investment in Toyota, irrespective of that events actual impact on Toyotas business. It should be clear from this short case study that the risks faced by investors in Toyota cannot sensibly be summarized in one number (e.g. standard deviation)and, indeed, that not all of the risks can easily be expressed numerically. The dangers are oversimplification, standardization of analysis, and consequent overconfidence. This is particularly so where investors rely on the perceived safety of a firm with a large capitalization that is quoted on a major stock exchange, which, although generally helpful from a liquidity perspective (actually one of the main benefits), is no panacea, and is no substitute for doing ones own research (q.v. Enron, WorldCom). What we should really be worried about is the risk of loss in a given investment, not necessarily increased volatility (indeed, holders of options warmly welcome increased volatility since it increases their assets value). Thus, avoiding bad situations in the first place is probably the most effective risk management tool of all. Warren Buffetts approach as a value investor has ensured that he has avoided such market collapses
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as the technology bust of 2001, since the valuations of such stocks were too high for him to consider investment.

Facing Uncertainty and Unknowns in the Real World

In 2002, the US Secretary of Defense, Donald Rumsfeld, gave one of the most abstruse press conferences in the history of the English language, during which he created his now infamous paradigm of known knowns, known unknowns, and unknown unknowns. Although it confused the world at that time, it nonetheless creates a useful framework for the analysis of knowledge and the risks that we face. To his three categories I would add the additional class of unknown knowns, so that our knowledge of the world and its risks is broken down as in Table 4. Table 4. Risk categories by knowability Category Known known Meaning Risks we know about now and can predict and quantify with reasonable accuracy now Examples Current volatility Short-term inflation Secular demographic factors Expected default rates

Known unknown

Risks we know about now, but Firm/industry demise Long-term cannot predict the timing of and/or inflation Changes in consumer quantify accurately now tastes Actual default rates Risks we forgot we knew about Risks we cannot know about now Universal banking Portfolio correlations in bear markets 9/11 terrorist atrocity Madoff fraud Arab uprisings 2011
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Unknown known Unknown unknown

An honest appraisal of the risks that we face and an acknowledgement that there are risks that we cannot know about ex ante is the first step to better risk management. An important factor in our favor when managing risk is that the symptoms of risk (i.e. how any risk affects the value of our portfolio) are far less numerous than the causes. This is particularly helpful when trying to deal with the unknown risks that we face. In fact, if we look at the examples of known and unknown risks detailed in Table 4 and their potential mitigators and hedges, we can see that the action to be taken is very similar in nature. This is shown in Table 5. Table 5. Categories of risk and hedging strategies Risk Current volatility Short-term inflation Secular demographic factors Expected default rates Firm/industry demise Long-term inflation Changes in consumer tastes Actual default rates Universal banking
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Category(ies) Instrument-specific Inflation Inflation Instrument-specific Instrument-specific Inflation Instrument-specific Instrument-specific Liquidity Liquidity Inflation Instrument-specific Inflation

Mitigator(s)/Hedge(s) Diversification Commodity hedging Commodity hedging Diversification Diversification Commodity hedging Diversification Diversification Liquidity planning Liquidity planning Commodity hedging Diversification Commodity hedging
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9/11 terrorist atrocity Madoff fraud Arab uprisings 2011

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In summary, we should be allowing for more risk than that which currently is clearly predictable. The $64,000 question is, of course, how much more liquidity, inflation hedging, etc., should we be incorporating into our risk management program? Since every portfolio (and its underlying liabilities) is different, it is impossible to generalize. However, in setting the quantum of the portfolios contingent risk protection and other risk management measures, the following issues must be addressed: How can the concentration of risk be reduced? How much loss can the asset portfolio bear? How likely is it that the portfolio will be able to recover from a significant loss? What is the investment horizon (i.e. how long does the portfolio have to recover any losses)?

Conclusion
The reality of investment risk in asset management (and other spheres of finance) has proved itself to be more complex and far less prescriptive than the implicit description of risk in the models that were originally conceived by the pioneers of modern portfolio theory. Unfortunately, no clear alternative to the intuitively appealing models centering on standard deviation, confidence intervals, and correlations is immediately apparent, but to continue to rely too heavily on these models in their current form, knowing what we now know about the nature of the modern world and the empirical behavior of investors, is negligently dangerous. Going forward, knowing more about individual investments and their potential pitfalls, rather than relying on blind diversification, is a good first step. A good second step is greater humility in admitting to ourselves that there are some things we do not know and others that we simply cannot know at any given point. Making additional allowances for these unknowns (which will inevitably cause a drag on portfolio returns in the short run) is probably the greatest Rubicon that the asset management industry needs to cross.

Making It Happen
Understand as much as you can about each investment in your portfolio, but accept that you cannot know everything. Understand the known and potential liquidity requirements of your portfolios liabilities and how these relate to the liquidity of the portfolios assets. Try not to make rash decisions: if you have made considered investment choices for the long term, dont be panicked into changing them when short-term crises arise (which they will). Dont rely on numbers alone: any statistics should only support a robust investment proposition that has intuitive as well as logical appeal.

More Info
Books:
Gardner, Dan. Risk: The Science and Politics of Fear. London: Virgin Books, 2008. Shiller, Robert J. Market Volatility. Cambridge, MA: MIT Press, 1989. Taleb, Nassim Nicholas. Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets. New York: Texere, 2004.

Report:
Sewell, Martin. Behavioural finance. Working paper. April 2010. Online at: www.behaviouralfinance.net/behavioural-finance.pdf

Websites:
CFA Institute publications: www.cfapubs.org EDHEC-Risk Institute: www.edhec-risk.com

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Notes
1 news.bbc.co.uk/1/hi/business/7883409.stm 2 tinyurl.com/b25pre 3 Financial Services Authority. The Turner review: A regulatory response to the global banking crisis. March 2009. Online at: www.fsa.gov.uk/pubs/other/turner_review.pdf 4 Benartzi, Shlomo, and Richard H. Thaler. Myopic loss aversion and the equity premium puzzle. Quarterly Journal of Economics 110:1 (February 1995): 7392. Online at: dx.doi.org/10.2307/2118511 5 Kahneman, Daniel, and Amos Tversky. Prospect theory: An analysis of decisions under risk. Econometrica 47:2 (March 1979): 263292. Online at: www.jstor.org/stable/1914185 6 De Bondt, Werner F. M., and Richard Thaler. Does the stock market overreact? Journal of Finance 40:3 (July 1985): 793805. Online at: www.jstor.org/stable/2327804 7 The case of Brian Hunter at Amaranth during 2005 and 2006 is interesting. Having made a reported US $75100 million bonus in the previous trading year, the compartmentalization theory would suggest that the excessive risk-seeking behavior exhibited by him in the subsequent trading year (which resulted in losses of Biblical proportions) was due to Hunter having money in the bank which he felt he could afford to gamble with. 8 Shiller, Robert J. Radical financial innovation. Cowles Foundation Discussion Paper No. 1461. April 2004. Online at: ssrn.com/abstract=537402 9 Taleb, Nassim Nicholas. The Black Swan: The Impact of the Highly Improbable. New York: Random House, 2007. 10 Whether this high incidence is real or perceived is largely irrelevant; even if the media industry biases reported news to bad events in order to sell more newspapers, the effect on sentiment is the same. The effect of this is that our probability density function is negatively skewed. 11 Universal banking is a business model whereby investment banking and deposit-taking activities are combined one organization. Universal banking was effectively declared illegal in the United States in 1933 (the GlassSteagall Act, 1933) following the Wall Street crash of 1929, the failure of around 10,000 banks, and the ensuing Great Depression. The GrammLeachBliley Act, 1999 (GLB), repealed those parts of the GlassSteagall act that prevented universal banking. GLB was widely blamed for exacerbating the financial crisis of the late noughties. Paul Krugman, the Nobel prize-winning economist, was quoted in the New York Times (March 2008) as saying that Senator Phil Gramm was second only to Alan Greenspan (who pumped unprecedented and, perhaps, unnecessary liquidity into the US financial system) in terms of responsibility for causing the crisis. 12 Ibid.

See Also
Best Practice Asset Allocation Methodologies The Case for SMART Rebalancing Private Equity Fund Monitoring and Risk Management Understanding the Role of Diversification Finance Library Inefficient Markets: An Introduction to Behavioral Finance

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