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The reality of risk

Chris Gilchrist

Finance and portfolio theory did huge damage to everyone in the investment field when they redefined risk to mean volatility. The sooner we abandon this fiction and its black-box fantasies the better for all concerned.

Everyone apart from a few financeland boffins understands risk to mean what it says in the dictionary: “The chance of loss or injury.”

Volatility, the variation in investment returns, has only an indirect relationship with risk. It is only identical with risk in portfolio theory models that were never more than hypothetical and have never proved to have beneficial effects.

Because parts of these academic models were widely adopted by asset managers, they had to define risk as volatility. Regulators did not have to, but went along with the fashion – another instance of “regulatory capture” or Stockholm syndrome, which an unkind observer could describe as the FSA’s modus operandi.

The reason for the risk volatility mistake is the desire to measure things in the belief that this enables us to control them. Volatility can only be measured using statistical tools that are valid only when dealing with “normal distributions” that do not represent what happens in investment. Hence the absurdity of the “6-sigma event”, one where returns fall outside six standard deviations of the mean. Dozens of these occurred during the credit crunch, making nonsense of models that said such an event should occur only once in four billion years.

More fundamentally, the assessment of volatility using probabilistic tools is only valid if the future resembles the past. They do not work where there is genuine uncertainty. The absurd pretensions of portfolio theory, with its calamitous rear-view mirror perspective, misled everyone into believing there was less risk out there than there really was.

The right procedure for getting people to understand risk is to forget the algebra and ask them to quantify their needs – definite amounts of capital or income at a future date.

The next question is “How much would you suffer if you had less?” It is only in relation to this potential for loss and injury that anyone can really
judge the merits of an investment. If the potential for gain and loss is assessed by deriving a range of possible outcomes from the range of
historical returns from the major asset classes (as per the Barclays Capital Equity-Gilt Study) then you have as good a handle on the risk-return balance as you can get but reality will sometimes deviate from these projections, as it did in 2008.

As Warren Buffett has often said: “More maths doesn’t improve investing.” And his mentor Ben Graham, the creator of value investing, also rubbished the use of calculus or higher maths in assessing investments. Markowitz’s portfolio theory is admired for its maths rather than for its utility.

Investment is only partially susceptible to quantification because investment is not a science but an art. Indeed, one of Buffett’s best followers,
Robert Hagstrom, has written a book provocatively entitled, Investing – the last liberal art.

To prove the point, take this from Buffett himself: “We’ve never succeeded in doing a good deal with a bad person”. What have volatility or stochastics got to do with this most fundamental source of risk?

Chris Gilchrist is director of Churchill Investments and editor of The IRS Report


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There are 10 comments at the moment, we would love to hear your opinion too.

  1. oh my god there is somebody still out there from the real world, couldnt agree more,

  2. Incompetent Regulators Awards Team 29th March 2010 at 2:07 pm

    And here we now have a regulator and it’s useless staff don’t even have the basic understanding of investments whikst most do not have any experience or even qualifications in this field.

    Whilst on this subject of risk/volatility, having your money is cash in the likes of RBS was probably more risky than being in shares or unti trusts. As the any capital in these accounts were only saved by the propping up by the tax payer.

    Whilst being lectured by the Fine Slapping Authority in risk, what were they doing whilst monitoring the banking sector whilst leading up to the collapse?

  3. Having read this article I am confused. We are told that volatility is not a great tool to use in discussing risk (I disagree) but not really given any alternative. Asking people to provide monetary amounts of capital/income required in the future doesn’t give too many clues; a large sum required implies taking a lot of risk and a small sum very little but it does not address how risk averse the client might be. It does not provide any indication as to the asset classes and mix most appropriate.

    Volatility may not predict the future with great accuracy but it does give an indication of expectations. Are you happy that your returns in the future will likely fluctuate at this rate or that one?

    In my experience, this is a very useful measure of risk aversion enabling an appropriate mix of assets to be acquired.

  4. “Volatility, the variation in investment returns, has only an indirect relationship with risk”. Rubbish, it has everything to do with risk. What are you risking when you invest money in anything related to investment markets? You’re risking the possibility of the value of your investment having a rip-roaring few years followed by an unexpected and possibly disastrous slump.

    And anyway, all the traditional criteria by which an investment portfolio is constructed have gone out of the window over the past couple of years. Established, mature and supposedly responsibly run western markets all bombed (but are now recovering). Would a good proportion of a portfolio in Bonds have helped cushion the damage? Hardly, because most bond funds bombed too, many of them at least as badly as their equity counterparts.

    And what of all those flighty, risky, immature Far Eastern and Emerging Market funds? Largely unaffected by the banking crisis and the credit crunch, they suffered a bit of a lurch but then just kept on steaming ahead.

    Theoreticians will still be debating in a 100 years time the best way to put together a properly risk balanced portfolio, but the fact is that investing directly into just about any market or into any fund that invests directly into such markets is going to mean a roller coaster ride. And now we don’t even know any more which sectors are prone to the most alarming ups and downs.

    All you can do is diversify and follow the best management teams with the strongest track reocrds in the hope that they’ll manage to keep on delivering the goods for as long as you stay invested with them.

  5. Investment Professional 29th March 2010 at 2:57 pm

    This article is absurd and redundant.

    The second paragraph defines risk as “the chance of loss or injury”. The third defines volatility as “the variation in investment returns”. Risk is purely downside whereas volatility includes upside as well. Downside volatility is basically the same as risk – the probability of loss and by how much.

    This article can be summed up in about three sentences with the first sentence of the sixth paragraph as the conclusion:

    “More fundamentally, the assessment of volatility using probabilistic tools is only valid if the future resembles the past.”

    Of course… anyone with half a brain can understand that. A large part of the skill in investing is assessing risk differently (and correctly) from everyone else.

  6. Risk, Volatility, to the majority of clients it is all pretty much bunkum. We need to know our clients and understand THEIR understanding of risk! However, non of any of the above is relevant if institutions can lie and hide their true asset positions and trade insolvently whilst promoting themselves as healthy companies. Due Diligence, on the investments bought and on the client that is buying is the only way, most so called advisers do not understand the true meaning of Due Dilligence, they sell what looks sexy at the time and pays the bills. Buffet is not a magician, he applied very simple principals to make him the richest man in the world. He always knew what he was buying through thorough research, gaining a full understanding of what he was buying and why he was buying and held it for a long period of time. Do we always know what who and why a manager has bought certain funds? Who is pulling his/her strings? How is it these managers, holding zillions of banking shares did not know the likes of NR, RBS Halifax etal were pulling the wool over their eyes. Yes it is easy to blame the regulator and say they are not qualified etc, but why was it that Standard Life ditched RBS before the cards tumbled, I know because I go and meet managers and ask the questions before I put my clients into their funds. Do you?

  7. Isn’t risk anything that can get in the way of you achieving your desired outcome? Investment risk probably does equate to volatility for most people, but don’t they also need to understand “outcome risk”? eg if you’re looking for income then its not only investment risk (or volatility) that represents risk, its inflation risk, longevity risk, loss of capital risk and, ultimately annuity rate risk.

    Risk is perhaps a complex cocktail that is best defined in relation to the outcome you are trying to achieve?

  8. @ Chris – Pretty much agree with all you have written.- Especially with “The reason for the risk volatility mistake is the desire to measure things in the belief that this enables us to control them”.

    I would guess that a number of your critics feel threatened by the thought that endless tea leaf reading is only of value in that it allows the adviser to charge their client more for guessing.

    Alpha, beta, stochastic…. though in a few histograms and a long and unintelligible report and only the bravest client would question the large bill for services often unnecessarily rendered.

  9. There are some good points in this article i.e. the importance of looking at an actual client’s financial planning objectives and not slavishly using ‘blackbox’ approaches to questionnaires etc.

    But this article is sloppy in its familiarity with the literature. For starters, I refer you to Ch.9, Markowitz (1959) ‘Portfolio Selection: Efficient Diversification of Investments’ where he first proposed to use semi-variance (i.e. loss) in place of volatility…

    Likewise, these statistical techniques can easily be used for assessing probabilities of shortfalls against financial planning objectives – and then *importantly* gauging a clients feelings and capacity for these as well.

    As for “misled everyone”, it certainly didn’t mislead me. I told everyone to sell in August ’08. But unless you subscribed to a particular brands of economics (‘Austrian’ for me), you wouldn’t have gauged what was happening.

    It was a failure of economists that misled IFAs and financial markets alike. Not a failure of using statistical techniques sensibly when advising clients.

    Yes, the asset-management industry disappeared up its own anus some years ago. But the FSA has for some years been surprisingly sensible when it comes to our market:

  10. It is now all the more tricky as all asset classes correlated for a short time. It is just a case of adding yet another disclaimer that

    “from time to time all asset clasess can and do correlate and can have a very damaging effect on even the most diverse portfolio”

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