The Anatomy of Financial Risk

The Anatomy of Financial Risk

Risk does not equate to volatility but is the likelihood of a permanent loss of capital – this remains the lynchpin of how Lumen thinks about risk. Maximum intrinsic value equates to minimum intrinsic risk!

Please read on…

Financial risk is the likelihood of a permanent loss of capital, i.e. the possibility of having to bail out of an investment at a loss without having the opportunity to recoup these losses. This is what financial risk truly is, period!

Instead, and ever since in 1952 Harry Markowitz came out with his classic study on Modern Portfolio Theory, risk has become synonymous with volatility. And volatility in turn had become “measurable” by the standard deviation of the past historical market movements. I.e., financial risk – or basis risk, country risk, default risk, delivery risk, economic risk, exchange rate risk, interest rate risk, liquidity risk, operations risk, payment system risk, political risk, refinancing risk, reinvestment risk, settlement risk, sovereign risk, underwriting risk, etc. — is regularly neatly and conveniently quantified by the most basic of statistical parameters: the standard deviation of a population which is (courageously) assumed to be Normally distributed. That is, the industry is quantifying and “managing” risk by looking at the proverbial rear view mirror.

To be sure, there are other “metrics” of risk besides the (in) famous standard deviation; some based on more “erudite” assumptions on the underlying distribution of past observations – e.g. Binomial distribution; the event is there or is not…risk on/risk off. There is also Relative Risk – or what is also commonly referred to as Tracking Error relative to a benchmark or similar. Nevertheless, all these ”risk” measures are  based on past history, statistics or comparative analysis…and as Warren Buffet is fond of saying “…if history is all there were to the game, librarians would be the richest people in the world”!

The advent of Big Data, Artificial Intelligence, and faster computer power has made “things” even worse, at least for some of us diehard, old fashion value investors. Many brilliant minds are now occupied by concocting ever-more complex statistical techniques and algorithms to harness risk. The tragedy is that all of them are looking at exactly the same set of data albeit from various angles, and all are expecting different results, an uncomfortable similarity with Albert Einstein (yes, the man that used real as opposed to artificial intelligence) definition of insanity: doing the same thing over again and expecting different results! For example, quoting statistics, a major U.S. investment bank famously defended its losses by simply stating that the 2008 Great Financial Crisis was an event with a probability of “…one in 10,000 year” — comforting especially for those that lost it all, right?! As we are fond of saying, Artificial Intelligence seems to have substituted Real Intelligence.

The trouble is that risk is by its very nature and definition totally random, accidental, unexpected, and impromptu.  Undeniably, risk can be perceived…but it can hardly be “precisely” quantified or predicted. Yet, there is an army of professionals that has made a distinguished career in quantifying risk and, by definition, attempting to predict the future, an obvious exercise in over confidence.

In addition, the dilemma is that “risk management” is part and parcel with portfolio construction, one of the two key components of successful money management, i.e.  security selection and portfolio construction.  That is, once that promising investments are identified, they are combined into a portfolio constructed on the basis of…risk! And given that risk is determined based on statistical assertions, portfolios are constructed by looking at the proverbial rear view mirror…once in 10,000 years, right!?

Rather than persevering in attempting to quantify risk via ever-more sophisticated quant/statistical complex albeit backward-looking algorithms, risk should instead be assessed through good old-fashioned fundamental investment analysis; that is understanding cardinal financial and economic laws linking economic and financial outcomes and driving market developments. Financial risk (i.e. permanent loss of capital), rather than being “precisely” quantified, can then be “skillfully” managed. That is applying an old-fashioned but extremely relevant investment tenet: risk is part and parcel with value and is inseparable and imbedded in the monetary value of ANY investment proposition; that is the risk of an asset is reflected and encompassed into the monetary value of that asset. In the end, the price of ANY investment does encompass three key ingredients: time value of money (represented by the risk-free rate), systemic or market risk (i.e. Beta), and idiosyncratic risk (i.e. alpha); two of these are difficult to precisely quantify theoretically and ex-ante.  However, and remembering Benjamin Graham, the father of Value Investing “…value is that margin of safety that must be large enough so that one’s capability of predicting the future [risk] becomes completely irrelevant”. Meaning: an investment perceived to be risky must have a cheap price/valuation with plenty of room to be wrong.

Thus, and for example, investment risk in the Euro Zone is the uncertainty generated by the monetary experimentation of Quantitative Easing by the ECB in order to save the botched attempt of a currency union in. The question with regard to risk than is: are Euro Zone assets cheap enough (i.e. do they have a large margin of safety) to compensate an investor for the possibility of a break up in the Euro…and therefore a permanent loss of capital? More to the point, are negative yields on 2-year Italian Treasury bond realistically “large” enough to compensate for the risk of a Euro break up? Or, are Italian bonds risky?  Well, according to the current practice of confusing risk with standard deviation, Italian Bonds are apparently not risky; seriously?!

In conclusion, volatility, in whatever statistical format, is very different from and is not the same as financial risk; that is volatility should be better left to the traders and speculators, by all means necessary and legitimate market participants and provider of liquidity. Investment risk on the other hand is better left to the investment professional, tasked with the systematic discovering of value…that is that margin of safety large enough to offset any potential unpredictable and unquantifiable risk.

Simon E. Nocera

San Francisco, February 10, 2017