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Risk is the likelihood of losing your hard earned wealth; Volatility is the wobbles

Wednesday, August 24th 2011, 7:26AM 7 Comments

by Goldie

We all learned from the finance company debacles that valuing a portfolio with a capital item that remained at the same value, lulled many financial planners into a false sense of security. That is, using finance company debentures in investment portfolios reduced volatility and so they assumed this was reducing the risk in the portfolio. The capital value of a debenture in a finance company never reflected that company’s strength or otherwise. Unfortunately for their clients, a permanent loss of capital was a massive risk. So, why do research houses still use volatility as the only measure of risk? Correct me if I am wrong but quantitative research and hence technical analysis is the sole basis of most ratings. And, what does that measure – the past. Sure, volatility is one measure but it is not the only answer to understanding risk in a portfolio. I believe the clients’ of financial planners have a very clear understanding of risk, “Will I lose my money?” What does not seem to be in the forefront of minds with those who construct portfolios, is whether the selected investments can battle through a huge storm without total loss? The true test of risk – the survival of a Black Swan Event (of which we seem to have quite a few in recent years). The Black Swan Theory was developed by Nassim Taleb and he argues the silliness of trying to predict the unpredictable. Nissim Taleb said: “We Don’t Quite Know What We are Talking About When We Talk About Volatility”. If you believe the investments you have chosen will survive severe storms (irrespective of the volatility they may suffer during the storm) then you have de-risked your client’s portfolio. If on the other hand something is dropped into the portfolio because the capital value is stable, maybe it is actually stagnant (i.e. difficult to value or not regularly valued), then risk persists. For this very reason, some of the hardest hit during 2008 were the ‘so-called’ conservative portfolios. You would be better off in most circumstances ignoring volatility – it is probably one of the contributors to many losses incurred since the jolly measure was introduced as a proxy for risk. Sorry Mr Markowitz. Can anyone enlighten me on why so many slavishly follow and utilise research house material which is a regurgitation of the past with one of the main measures applied being volatility? Anecdotal evidence would suggest we would be better off without them. Maybe it is just simple ol’ human nature: “Got to have someone to blame when the going gets tough?”
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Comments from our readers

On 24 August 2011 at 8:58 am Red beard the privateer said:
So we now have a punter who has read one easily digested book and has a private smirk whenever someone mentions volatility. Bravo!

1) A number of financial planners didn't use debentures for the capital stability aspect. In many cases it was significant contractions in credit spreads that both drove investors and forced advisers to look for investments with better rates. I had a number of people walk away because I would not recommend sub-investment grade debentures even though they were paying a whopping 0.5% more than AA rated bonds. There was also the case of dodgier advisers chasing better commissions for themselves - which is a prime reason why you now have the FAA and Code of Professional Conduct.

2) Volatility in this piece is used as if there is only one way to measure it. For anyone interested in Taleb 101, then the general theme is that markets go up, and markets go down (with pricing being historical). The reason why volatility is used as a measure is because it is something that is easily understood by the mainstream. Sure the measure is historical, but it provides an indication of what could happen in the future. There are a number of analysts who rely too much on this data as gospel. That is a foolish approach. But it is important to understand the nature of an investment (i.e. how it is likely to move).

What Taleb is getting at in his books (when he isn't too busy telling you how clever he is) is that there needs to be a better understanding of risk without getting too tied up in historical performance. The ultimate risk is total loss - it happens. This is something that needs to be communicated to clients. Back of the envelope volatility calculations have their place (which is why "Mr Markowitz" is still relevant). Also, it must be understood that not all volatility (positive volatility) is bad. Discussing likelihood of performance is perfectly acceptable, but it must be properly framed as being based on past performance.

3) Volatility is quoted because it is now entrenched in law in many countries. You will also note the range of other research that is performed on investments and markets that needs to be analysed alongside volatility measures (some of it is called forecasting).

(I suggest you) sit down, have a good think, and come up with a viable, easy to understand, and flawless approach to risk measurement.

For myself, I will continue to use these measures whilst keeping one eye on what economists say - as it is always important to see when the sheep are going to jump off of the cliff.
On 24 August 2011 at 10:02 am Abouttime said:
Can you educate the FMA "monitors" please. From what I hear they are going to punish those advisers not slavishly following the asset allocation and approved investments of the tried and failed research houses.
On 24 August 2011 at 10:07 am Independent Observer said:
Great Stuff

I have been a long-term advocate for absolute returns rather than meaningless benchmark returns. Unfortunately the latter has been designed by the industry, for the benefit of the industry. That is – along the way, we forgot to ask the investor what was most important to them – performance against a benchmark, or performance against leaving their money in the bank (their benchmark).

The challenge of identifying skilled absolute return managers is that they (in the main) don’t conform with traditional research house methodologies – which tend to have a strong bias to pigeon-hole comparison against benchmarks. Absolute return managers often get lumped into an alternative basket, or misdiagnosed as hedge fund managers or such like. This means that they become difficult to slot into portfolios that are designed around Modern Portfolio Theories (the key word being Theories).

I suspect that the future for our industry will be a continued promotion of irrelevant benchmark returns by institutions with strong vested interest, with an acceleration towards delivering relevant risk adjusted absolute returns by those advisers targeting more sophisticated investors. Ultimately the institutional approach will produce a commoditised outcome, (whereby price & brand will be significant points of differentiation) with the remaining advisory force actively seeking absolute return talent who are without looming capacity constraints.
On 24 August 2011 at 10:32 am MPT Heretic said:
Sorry can't help you with your question regarding the use of research house ratings since we don't use them.
Completely agree with your argument that risk has been (and continues to be) misunderstood and mispriced.
However, volatility cant be ignored. It is important in the context of an investors time frame and also their psycology. If something unforeseen happens and they are forced to cash-up rather than ride out the "wobbles" then capital is lost.
Mr Markowitz wasn't the one incorrectly applying MPT in the context of today's investment opportunities.
On 24 August 2011 at 10:50 am Thom Bentley said:
The true lesson here is not that volatility doesn't measure the risk of losing money (it doesn't) but that you should be ESPECIALLY wary of investments that have no apparent volatility. If any product manufacturer comes to you with a fund/product that shows straight line performance with returns better than cash or some other 'risk free' proxy, beware.

However, just because an asset class doesn't trade regularly (e.g. private equity, property) it doesn't automatically mean it is more risky.

Nassim Taleb's central argument is that many risk measures are based on gambling outcomes which have normal distributions, but markets are not like roulette wheels. There are fat tail risks which, whilst they may be rare, have a huge impact on returns.

Any good ratings company will use qualitative measures, such as investment process, investment philosophy, quality/experience of the investment managers, the robustness of middle/back office systems, ownership structure, business risks. A ratings company that doesn't include qualitative measures is only doing half the job (or less).

One thing missing from this article is any alternative measure of risk. How do you judge the risk of losing money on an investment? How do you create portfolios that are immune from Black Swans, when by their very nature you can't foresee a Black Swan event?

By the way, we have always had Black Swan events, they're not just something that appeared in recent years. The demise of the finance companies in NZ was not a Black Swan event though - plenty of people saw that one coming.
On 24 August 2011 at 5:13 pm traveller said:
Asset allocation is surely the result of how the allocator, or his/her research sources, reads the outlook for the economy and the markets.
That will also be reflected in asset selection. If the FMA is going to be reliant on research houses asset allocation models, which one will they choose especially if one is bullish about shares and the other one bearish?
And this ignores issues of market timing which in the short term can have a major effect on portfolio performance.
On 29 August 2011 at 9:44 am Paul said:
I don't think Taleb was thinking about NZ finance companies when he was writing about Black Swans. He was interested in unanticipated risk or unforseen risks. The risk of tiny, low rated or unrated, poorly capitalised, badly managed finance companies with untraded debentures going bust during a downturn was entirely predictable to the vast majority of investors.

This is why about $90bn of New Zealander's money is invested in well run highly rated banks while even at the peak, finance companies only attracted about $12bn and the largest portion of that was in UDC, a well run highly rated company with a well capitalised parent.
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