The increase in computational power has definitely made life easier for the finance industry. Tasks that once would have taken hours and hours to do by hand can now be done with the push of a button and calculated through algorithms or formulas on a spreadsheet. At times it feels like I have more market and economic data at my fingertips than I know what to do with.
The downside of this boost in productivity through technology is that it becomes easier than ever to trust your models and not question the outcomes. People often forget there’s always an element of garbage-in, garbage-out to every model. If you don’t understand the inputs and the assumptions the answer your model gives you won’t be much help.
One of the areas where I feel this reliance on computers and formulas can be taken too far is in the realm of risk management — or more specifically risk measurement. There’s a big difference.
Far too many financial professionals assume that risk measurement is the same thing as risk management. So they rely on fancy quantitative risk models and volatility-based ratios under the assumption that greek letters in a formula will be able to alert them to elevated risk in their portfolios. There’s nothing wrong with quantitative models. They can be helpful when they’re used correctly, but they are not the be-all, end-all of risk management. They are a tool, not a plan.
The focus on quantitative risks leads many to miss their more important, but harder to measure, qualitative risks. Many investors — professional and amateur alike — have a difficult time figuring out what their trues risks are in the first place.
In The Aspirational Investor, former Merrill Lynch Chief Investment Officer Ashvin Chhabra has an interesting way of defining your risks as an investor that I really liked:
Personal Risk: You must protect yourself from the anxiety of a dramatic decrease in your standard of living. Thus, you must immunize yourself from personal risk: the devastating impact of not being able to meet your essential cash needs, regardless of the performance of financial markets.
Market Risk: You must maintain your lifestyle by earning a rate of return in the financial markets that is comparable to the increase in the cost of living. Thus you will probably have to take on market risk. This is the risk, according to Markowitz, that cannot be diversified away through portfolio optimization.
Aspirational Risk: In order to create the possibility of wealth creation and wealth mobility, or to fulfill your aspirational goals, you may decide to allocate capital to investments or business ventures that involve idiosyncratic risk and the potential for substantial capital gain or loss.
When considering your risk profile, you always have to take into consideration your (1) willingness to take risk, (2) your need to take risk and (3) your ability to take risk. That’s basically what Dr. Chhabra is describing here.
People flock to quantitative risk measurement techniques because it can be very difficult to see meaningful changes in your qualitative risks. Things in your life don’t tend to fluctuate nearly as much as the financial markets. It can be boring to define and remind yourself of your goals once a year or so because so many financial goals take place way out into the future. It’s easier to focus on short-term market risks when your true risks are so long-term in nature.
This is something that the short-term nature of the financial services industry doesn’t do such a great job at. The constant short-termism makes people and organization lose sight of their true goals, desire and objectives.
The team over at GestaltU had some really great descriptions about the qualitative aspects of risk in their recently released book, Adaptive Asset Allocation. A few of my favorite passages:
Those who judge their portfolio by its performance relative to some narrow benchmark are focusing on an issue that is largely irrelevant to their ultimate financial success.
The only benchmark that you should care about is one that indicates whether or not you’re on track to accomplish your financial goals.
Risk is measured as the probability that you won’t meet your financial goal. Investing should have the exclusive objective of minimizing this risk.
Goals-based invested can be difficult because it involves delayed gratification and a long-term mindset, but in the grand scheme of things your biggest risk as an investor is putting yourself in the position of not achieving your goals.
Sources:
Adaptive Asset Allocation
The Aspirational Investor
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Now here’s what I’ve been reading this week:
- 3 things you need to know about market valuation indicators (Dash of Insight)
- The pain gap in stocks (Motley Fool)
- The active management industry grew too fat (Evidence-Based Investor)
- The dirty little secret of risk vs. returns (Aleph Blog)
- 10 cognitive biases that affect your every day decisions (Big Picture)
- Success = analysis + communication (CFA Institute)
- Why God sent financial advisors into the world (Reformed Broker)
- Why the post-recession world doesn’t scale (Csen)
- One model to rule them all (Tyler Hogge)
- Early retirement and comparative advantage (Finance Buff)
- Chasing returns is not a great idea (Dynamic Beta)
- Advisor awards are not always as they may appear (A Teachable Moment)
- What is the value of the active management industry? (Philosophical Economics)
