FACING THE CONSEQUENCES

Peter L. Bernstein
.Risk is about how we make decisions, and only incidentally about
the math that we employ to reach those decisions. Knowing how
it works is just the beginning. Knowing how to use these tools is
the introduction to wisdom. And that is no easy task
At its roots, risk is about mystery. There would be no such
thing as risk if everything were known.
Pascal : Reason cannot answer. That is what life is all about:
dealing with problems to which there is no certain solution and
where any kind of rational decision is often impossible to define.
Obsession with risk management focuses too intently on the
instruments of the management and measurement of risk.
Most brilliant mathematical geniuses will never be able to tell
us what the future holds.
what matters is the quality of our decisions in the face of
uncertainty.
Dominance of decision-making over the analysis of probability

relationship between risk

and increases
timewith time is obvious
The notion that uncertainty

but Stocks for long run type of argument and Dow 3600
assume we know more about the long run than we know
about the short run.
If you do not know, you have no choice but to base your
asset allocation decisions on the consequences of choosing
the wrong allocation.
. Consequences, not probabilities, determine the
decisions that matter. Diversification is still the
optimal strategy for the long run.
Risk in our world is nothing more than uncertainty about
the decisions that other human beings are going to make
and how we can best respond to those decisions
outcomes are uncertain, but we have some control
over what is going to happen or at least some control
over the consequences of what does happen. That is
what risk management is all about.

|Value investors notion of risk

Warren Buffet says in Berkshire Hathaways
1993 Annual Report:
We define risk, using the dictionary terms, as the
possibility of loss or injury. Academicslike to
define investment risk differently, averring that it
is the relative volatility of a stock or portfolio of
stockscompared to a large universe of stocks.
Employing data bases and statistical skills, these
academics compute with precision the beta of a
stock and then build investment and capital
allocation theories around this calculation for a
single statistic to measure risk. For the owners of
a business and thats the way we think of
shareholder, the academics definition of risk is far
off the mark.

Charles Brandes says in Value Investing Today

Volatility is measurable, uncertainty is not defining
volatility as risk (as MPT does) obscures the true definition
of investment risk as the possibility of losing money.
Beta is used primarily by those who are looking at the
whole market (or large numbers of stocks within it) and
who dont look in detail at the fundamentals of specific
companies. As I have shown for value investors, this
concept is irrelevant and downright dangerous at worst. F
Value investors definition of risk not a theory, nor
an equation, but a common sense expression of how
to avoid losing money
.No theoretical formulas or equations, only advice on
how to value businesses. Few if any assumptions are
necessary

Clear and present danger: the trinity

of risk James Montier

Risk isnt a number, it is a concept or a notion. permanent

loss of capital.
Valuation risk . Buying an asset that is expensive means that
you are reliant upon all the good news being delivered (and
then some). There is no margin of safety in such stocks.
Business risk . Danger of a loss of quality and earnings power
through
economic changes or deterioration in management.
Challenge : to assess whether changes in earnings power are
temporary or permanent. The former are, of course,
opportunities, the latter are value traps.
Balance sheet/financing risk . presence of financial weakness
that may detract from the investment merit
these risks get ignored by investors during the good times,
but in a credit constrained environment they suddenly
reappear on the agenda

Over-quantification hides real

risk. James Montier

Finance has turned the art of transforming the simple into the
perplexing into an industry.. The reason for this obsession with
needless complexity is clear: it is far easier to charge higher fees
for things that sound complex. Ben Graham : Mathematics is
ordinarily considered as producing precise and dependable
results; but in the stock market the more elaborate and abstruse
the mathematics the more uncertain and speculative are the
conclusions we draw there from ... Whenever calculus is brought
in, or higher algebra, you could take it as a warning that the
operator was trying to substitute theory for experience, and
usually also to give to speculation the deceptive guise of
investment
Skepticism is one of the key traits that many of the best investors
seem to share. risk management industry seems to believe
measure it, and it must be useful. In investing, all too often risk
is equated with volatility. This is nonsense. Risk isnt volatility, it is
the permanent loss of capital.
Volatility creates opportunity.

PSG Angle : Is the world getting riskier?

Popularity of the standard deviation due to the ease at
which it can be calculated
. The problem with standard deviation is that it really
only focuses on the short-term oscillation of prices or
returns and does not give insight into the real risk of the
investment.
A clear example of where standard deviation failed in
indicating risk was during the later part of the bull
market, just prior to the financial crisis. Over the long
term the annualised standard deviation of the All Share
Index is around 20%. Prior to the market crash the
standard deviation dropped significantly to below 15%,
indicating that an investment in the market was
becoming less risky when in actual fact, the opposite
was true.

Risk By Any Other Name Michael F. Farrell

At the core of investing, risk is joined at the hip
to reward. And like the sailor who spends his life
dealing with the unknowns of the sea and never
conquers his nemesis but develops a profound
respect for it over time, successful long-term
investors have developed a respect for stock
market risk. Part of that respect comes from
understanding the different ways the market
considers risk
Niels Jensen: Trivial risk is the risk that the stock
market will go up or down by 5% tomorrow,
while real risk is the risk that the market will fall
so much that it will wipe out your investment.
Such market corrections are uncommon and are

A VIEW ON APT
M Farell
APT is a model of expected returns that relates returns to a set of
factors, akin to the childrens game I spy. APT is very similar; you
have a set of returns, but you dont know how they were
generated. You ask a series of questions such as: Were your
returns generated by changes in interest rates or, say, by returns of
utility stocks? After enough questions, the theory says that you
should be able to identify enough factors to describe the managers
returns fairly well. APT tells you how it can be done, but it doesnt
tell you what factors to put in the model. APT analysis is a good
evaluative tool, but it is only as good as those who use it.
Barras APT Analysis, probably the most widely used service,
measures 12 individual risk factors. To call these risk factors is
a stretch, and heres why. The first risk factor is value. market
capitalization (size).
to label these factors as risks muddies the whole discussion, we
are often asked why so much of our returns are attributable to the
risk factors. We respond that these same factors are what drive
our models in selecting stocks, and are also factors used by some
of the greatest investors of all time. problem is one of semantics

Berkshire Hathaways portfolio

through Barra APT Analysis
Gained 7.2% per year over this period (vs. the S&P 500 6.1%). 6%
of those returns came from their exposure to the market, 1.6%
from market timing, 1.7% from sector bets. But heres the kicker,
they lost 2.5% due to asset selection (i.e., individual companies
our APT analysis employs some shaky assumptions.
Imagine how this analysis can be misapplied in looking at
investors of lesser abilities. There is definitely a place for APT; just
dont call its components risk factors and do be aware of the
cost to potential long-term performance of minimizing exposure to
those kinds of risk.
In evaluating investments and the trade-off between the potential
rewards and possible costs of seeking those rewards, it is
important to keep in mind all the forms and definitions of risk.
After single-mindedly focusing on the risk of relative
underperformance and tracking error in the boom years, investors
have swung to trying to reduce or avoid risk altogether, turning to
such tools as APT to do so.

Dont Fight the Last War

Lessons from the Battlefields of Risk Management
our brains are not calibrated to deal with the
unexpected. Most of us believe we are good risk
managers but in reality we are not. Most of us trust that
risk can always be quantified and expressed through
some fancy modelling whereas, often, it cannot
The world is not normal, yet universities continue to teach
our young students the wisdom of Markowitz and Sharpe
which brought us modern portfolio theory and, more
specifically, the capital asset pricing model. Garbage In,
Garbage Out, as they say.
Hyman Minsky Financial Instability Hypothesis
Stability breeds instability for several reasons key
amongst them is our inclination to look in the rear
mirror for clues about the future. Never fight the last
war when managing risk!

You cant model risk

Problems with Value-at-Risk
one day 1% VaR is $8 million -there is a 1% probability of losing
more than $8 million in one days trading. VaR assumes normally
distributed returns. Large negative returns occur more frequently
than one might expect, likely to lead to the risk manager
underestimating the frequency and magnitude of large losses.
Periods of relative calm and hence low volatility often precede
panic. VaR falls when volatility drops so, following a period of low
volatility, the risk manager will often allow the portfolio manager
to increase his risk taking, for example through increased use of
leverage. may walk straight into a financial storm with far too
much risk on his books.
Establishes the largest loss that the portfolio manager is likely to
lose 99% of the time (assuming the risk manager uses 1% VaR)
but it says nothing about what might happen in the remaining
1% of cases. After all, 1% still accounts for two, maybe three,
trading days every year. VaR is a quasi useful tool in the right
hands but a highly toxic one in the wrong hands.

Correlated mistakes

Effect mistakes have on financial markets are compounded when

they are correlated. A correlated mistake is one in which
investors share a common forecast that proves to be wrong. An
uncorrelated mistake is one where investors forecasts are
widely spread out symmetrically around the eventual outcome
(the The more correlated the forecasting mistakes of the
individuals in a market are, then the greater the market
correction (and hence volatility) will be in the market once the
Truth is learned
Fundamental Theorem of Risk: A Perfect Financial Storm will
occur when (1) investors have bets based upon very similar
forecasts, (2) their bet is a big one, for example, a bet on the
price of their principal asset (their house), and (3) both investors
and their banks are maximally leveraged. It can be demonstrated
formally that these three conditions will generate a Perfect Storm
of maximal volatility and note how perfectly these three
conditions were met in the US housing market collapse. The role
of excess leverage is to nonlinearly amplify market distress.

Abuse of statistics
Correlation is not causation. Just because a statistician can prove a
correlation between ice cream consumption in Angola and the number
of single mums in Panama doesnt mean that there is causation
Correlations unstable over time
Reinhart and Rogoffs work on debt versus economic growth ( We
have shown that public levels of debt/GDP that push the 90 percent
threshold are associated with lower median and average growth
Have since become gospel in many quarters. It is now widely
accepted that 90% debt-to-GDP is the invisible line in the sand.
Once crossed, you are doomed. The reality is that Reinhart and
Rogoffs work is based on a relatively small sample of countries of
such disparity in socioeconomic profiles that providing an average
figure is almost meaningless. It is akin to suggesting that yesterday
was a very pleasant day with an average temperature of about 20C
when in fact it was -10C at night and +50C during the day both
highly unpleasant. Reinhart and Rogoff did caveat their findings;
no, the blame lies firmly with all those who have taken those
findings at face value and used them out of context. Mistakes in
their study discovered

one-dimensional thinking

Investors incapable of focusing on more than one crisis at a time.

2011 became the year of the euro crisis; pretty much nothing else
mattered
Also clear from how markets treat economic news. In the U.S.,
(un)employment data have stolen most of the headlines in recent
months with less emphasis on other, and equally important,
economic statistics.
one-dimensional focus on the absolute level of P/E ratios when it
makes little sense to assess P/E ratios without taking the level of
interest rates into consideration.
risk on risk off mentality. In todays environment asset classes fall
into one of two categories they are either risk assets or safe haven
assets. Traditional diversification techniques have stopped working
with significant implications for asset allocation and portfolio
construction.
investor overconfidence. Most investors have a remarkable and
deeply fascinating ability to blame others for their mistakes whilst
giving themselves credit for all the correct investment decisions. Dont confuse genius with bull market.

Absolute return letter April 2011

Confessions of an Investor
Example of the complex nature of tail risk :
Disaster at the Fukushima Daiichi nuclear power plant was not a
direct result of the 9.0 earthquake which hit Japan on 11 March 2011.
In fact, all 16 reactors in the earthquake zone shut down within two
minutes of the quake, as they were designed to do. But Fukushima is
a relatively old nuclear facility - which requires continuous power
supply to provide cooling
When the quake hit and the primary power supply was cut off, the
diesel generators took over as planned, and the cooling continued.
But then came the tsunami. Around the Fukushima plant was a
protection wall designed to withstand a 5.2 metre tsunami, as the
area is prone to tsunamis. However, when a 14 metre high wall of
water, mud and debris hit the nuclear facility, the diesel generators
were wiped out as well.
Second line of defence batteries which could keep the cooling
running for another nine hours, supposedly enough to re-establish
the power lines to the facility. However, the devastation around
the area was so immense that the nine hours was inadequate . .

Tail risk
You cannot quantify a risk factor such as this one
because, if you try to do so, the prevailing models
will tell you that this should never happen. Take the
October 1987 crash on NYSE. It was supposedly a
21.6 standard deviation (SD) event. 21.6 SD events
happen once every 44*1099 years according to the
mathematicians amongst my friends1 (1096 is
called sexdecillion, but I am not even sure if there is
a name for 1099).
Welton Investment Corporation, severe losses
(defined as 20% or more) happen about 5 times
more frequently than estimated by the models we
(well, most of us) use.

birthday risk
Effectively, your birthday determines your ability to retire in relative
prosperity.
I would happily live with vast shortterm market volatility in exchange
for certainty about the level of my wealth and future income at that
date when I plan to retire. Wouldnt you? Wouldnt most people?
But if this is true, then why does most contemporary risk analysis
completely bypass this perspective and focus on shorter term risk?
Most people do most of their savings over a 15-20 year period from
their mid to late 40s until their early to mid 60s, the reason being that
most of us are net spenders through our education and until the point
in time when our children move away from home. It is therefore
extremely important how those 3 asset classes perform over that 1520 year period
wouldnt you just love to have retired in 2000? A solid 7.9% per year
for the preceding 19 years turned $1 million in 1981 into $4.2 million
in 2000, whereas those poor souls who retired in 1980 managed to
turn $1 million into no more than $1.1 million during the previous 14
year period. And those who are retiring today arent much better off
following an extremely volatile decade.

The problems with MPT

Three of the most important assumptions behind
MPT
Risk-free investments exist and every rational investor invests at
least some of his savings in such assets, which pay a risk-free rate
of return
Returns are independently and identically-distributed random
variables (returns are trendless and follow a normal distribution,
in plain English).
Investors can establish objective and accurate forecasts of
future returns by observing historical return patterns.
The concept of risk-free investing no longer exists, post 2008.
Banks are giant hedge funds which cannot be trusted and even
government bonds look dicey in todays world.
Secondly, returns are clearly not random. If you have any doubts,
just look at how the trend-following managed futures funds make
their money.
Experience,: historical returns provide little or no guidance as to
the direction of future returns.

Implications

Discard Notion of market portfolio being an appropriate

performance benchmark
in reality no meaningful distinction between strategic and tactical
asset allocation
Reject the notion that there is an optimal portfolio for each investor
from which he or she should only deviate tactically in the shorter
run;
markettiming deserves more credit than it is given;
MPT is a straitjacket preventing investors from rotating between
different classes of risky assets (with vastly different risk/return
profiles) as market conditions change.
Please note that this does not imply that asset allocation is irrelevant.
approach to asset allocation, where individual circumstances drive
portfolio construction, is likely to be superior to a more generic
approach based on a strategic core and a tactical overlay.
You can take the best from MPT and mix it with a good dose of
common sense and actually end up with a pretty robust investment
methodology

Jensens suggested solution

1. Do what you do best. Some investors are made for shortterm trading. Others are much more suited for long-term
investing (like me. MPT suggests that markets are efficient.
Nothing could be further from the truth. If you have spent your
entire career in the medical device industry, the chances are
that you understand this industry better than most. Use it when
managing your own assets. Insider trading is illegal; utilizing a
life time of experience is not.
2. Take advantage of mean reversion.. But be careful with the
timing aspect of mean reversion. The fact that an asset class is
over- or undervalued relative to its long term average tells you
nothing in terms of when the trend will reverse. A good rule of
thumb is to buy into asset classes when they are at least a
couple of standard deviations below their mean value.
3. Be cognizant of herding. This is how investment trends
become investment bubbles and fortunes are wiped out. You
can make a lot of money investing in fundamentally unsound
assets, as long as you can find a greater fool to whom you can
sell it at a higher price. It works fine but only to a point

 Think outside-the-box.! Who says that bonds cant be riskier

investments than equities? When circumstances change, you
should change your investment approach
5. Bring non-correlated asset classes into the frame.
managed futures.
6. Take advantage of investor constraints and biases.
example is the outsized impact a downgrade to below
investment grade may have on corporate bonds, as some
institutional investors are not permitted to own high yield
bonds and are thus forced to sell regardless of price when the
downgrade takes place.
Believe that less liquid investments will outperform more
liquid ones over the next few years for the simple reason that
the less liquid ones are struggling to catch the attention of
investors who, still smarting from the deep wounds inflicted in
2008-09, stay clear of anything that is not instantly liquid.

CAPM is CRAP James Montier

Is C(apital) A(sset) P(ricing) M(odel) C(ompletely)
R(edundant) A(sset) P(ricing)?
Empirical evidence does not fit CAPM predicitons
Fama and French
"The attraction of CAPM is that it offers powerful and intuitively pleasing
predictions about how to measure risk and the relation between
expected return and risk. Unfortunately, the empirical record of
the model is poor ? poor enough to invalidate the way it is used
in applications." Remember this comes from the high priests of
market efficiency
CAPM woefully under predicts the returns to low beta stocks,
and massively overestimates the returns to high beta stocks.
Long run : essentially no relationship between beta and return.
CAPM: market cap-weighted market index is mean-variance efficient
There is a large amount of evidence to suggest that CAPM is wrong in
this regard as well.
minimum variance portfolio generated higher returns with lower risk
than the market index.
fundamentally weighted indices (based on earnings and dividends, for
example) can generate higher return and lower risk than a capweighted index.

Separating alpha, beta

Shorthand for investors to express notions of value added by fund

managers, and market volatility, but they run the risk of actually
hampering the real job of investment to generate total returns.
A simple check for all investors "Would I do this if this were my own
money", Would you care about the tracking error of your own
portfolio?.
Among the really negative side effects of the performance
measurement movement as it has evolved over the past ten years
are: .It has tried to quantify and formulize, in a manner acceptable to
the almighty computer, a function that is only partially susceptible to
quantitative evaluation and requires a substantial subjective appraisal
to arrive at a meaningful conclusion Bob Kirby in the 1970s
Why does CAPM fail ?
Assumptions unrealistic. Like all good economists when I was first taught the
CAPM I was told to judge it by its empirical success rather than its assumptions.
However, given the evidence above, perhaps a glance at its assumptions might
just be worthwhile

Criticism: relative performance measurement

Ben Graham was also disturbed by the focus on
relative performance. At a conference one money
manager stated "Relative performance is all that
matters to me. If the market collapses and my
funds collapse less that's okay with me. I've done
my job."
That concerns me, doesn't it concern you?... I was
shocked by what I heard at this meeting. I could
not comprehend how the management of money
by institutions had degenerated from the
standpoint of sound investment to this rat race of
trying to get the highest possible return in the
shortest period of time. Those men gave me the
impression of being prisoners to their own
operations rather than controlling them... They

Markowitz Misunderstood
(MPT) should come with a warning label: Use with caution. Its
only as good as your assumptions.
Harry Markowitz Portfolio Selection in The Journal of Finance
during 1952.
The process of selecting a portfolio may be divided into two
stages. The first stage starts with observation and experience
and ends with beliefs about the future performances of
available securities. The second stage starts with the relevant
beliefs about future performances and ends with the choice of
the portfolio. This paper is concerned with the second stage.
conventional wisdom has forgotten or ignored the need to use
appropriate assumptionsthe essential first stage of
developing appropriate assumptions.
Must use observation and experience to develop beliefs
about the future performances. Although future performance
of the stock market cannot be predicted with certainty or
precision, through observation and experience we may be able
to at least refine the assumptions into above-average or below
average territory