Risky Business
Risky Business
Adam M. Grossman | Apr 9, 2023 Humble Dollar
OPEN A FINANCE textbook, and you’ll find discussions of volatility and beta, value-at-risk, the Sharpe ratio, the Sortino ratio, the Treynor ratio and many other quantitative tools for measuring risk. But what should you make of these metrics? Are they an effective way to control risk in your portfolio?
These tools do have decades of research behind them, and they can be useful. But I believe they’re also incomplete. Worse yet, they can be misleading. William Sharpe, winner of the Nobel Memorial Prize in Economic Sciences, once commented that his ratio was being “manipulated” by investment marketers “to misrepresent their performance.”
This highlights the first weakness of these quantitative measures: They’re formula-based and that gives them the appearance of being objective, but many of the inputs to these formulas are actually quite subjective. So subjective, in fact, that Sharpe has said, “I could think of a way to have an infinite Sharpe ratio.” To put that in context, a Sharpe value of more than two would be considered very attractive.
Another issue with quantitative measures is that risk is multidimensional. Consider the recent failure of Silicon Valley Bank. None of the quantitative measures referenced above would have detected the risk that ultimately brought down the bank. That’s because, in the end, the bank’s undoing had more to do with psychology than numbers. Depositors began to worry about the bank’s solvency, and those worries caused others to worry. Author Morgan Housel compared it to a stampede: A concern which, at first, was reasonable began to take on a life of its own, driving people over the line into irrational behavior.
The message I take from this: Risk is a bit like a hydra, the creature from mythology that had multiple heads. It’s awfully hard to pin down and even harder to quantify. Sometimes, situations that didn’t appear to carry any risk will suddenly experience a flare up. Other times, existing risks will present themselves in new ways and with a greater level of ferocity.
That’s what we saw in 2020, when COVID-19 emerged. There had been other virus outbreaks in recent years, including other coronaviruses. For several years leading up to 2020, in fact, the State Department had specifically called out the risk of a pandemic.
Here’s what intelligence analysts wrote in 2019, a year before COVID hit: “We assess that the United States and the world will remain vulnerable to the next flu pandemic or large-scale outbreak of a contagious disease that could lead to massive rates of death and disability, severely affect the world economy, strain international resources, and increase calls on the United States for support.”
That was hardly the only warning. But if a pandemic had been on our radar, why were we so unprepared? That gets at another reality of different risks: It’s hard to know when to take them seriously. If a particular risk hasn’t been seen before—or hasn’t been seen in a long time—it’s difficult to know how to think about it. How do we distinguish between risks that are real and those that are just paranoid notions?
Indeed, those who dwell too much on prospective risks face a risk themselves: They’ll be dismissed as worrywarts. Investor Nouriel Roubini, for example, has earned the nickname Dr. Doom for his perpetually glass-half-empty outlook. He’s a serious economist, but many people roll their eyes when he delivers yet another downbeat forecast.
Investor William Bernstein, in his book Deep Risk, discusses “the four horsemen” of portfolio risk. In addition to inflation and deflation, which are common concerns, he includes devastation and confiscation—the sorts of things that would be associated with a breakdown of civil society. Are these real risks? I wouldn’t dismiss them—and I credit Bernstein for being brave enough to raise these questions—but it’s also difficult to know what reasonable steps you might take to protect yourself against them.
Risk is tricky also because it’s a master of disguise. Even when we have a good understanding of a particular risk—such as market bubbles—we can still be fooled. Not unlike viruses, market bubbles mutate. They always come back looking a little different each time. That allows them to slip through our defenses. That, in fact, is how I would characterize much of what happened in 2021, when all sorts of newfangled investments rose to prominence—SPACs, for example, and thousands of new crypto “currencies.”
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