Is the common view of financial risk completely wrong?
Helo everyone. I'm a physicist looking to enter the HF space and I'm confused about how the notion of financial risk is measured and dealt with in this industry.
From what I see, finacial professionals usually associate the "riskyness" of an asset by how much its value "fluctuates" relative to the market. And furthermore, the larger this variance is, the faster the asset should appreciate relative to the rest of the market, with the ratio of the return of the asset relative to the market being given by the so-called "beta" of the CAPM. There is also the "alpha", which gives you the "expected return" on the asset. As I understand it, this allows the engineering of (allegedly ) low risk portfolios through strategies such as gathering many low alpha, low beta assets and using leverage to increase the return of the portfolio without increasing the beta (thus supposedly keeping the risk down). So, if I understand this correctly, when most people talk about the financial risk, they actually just mean volatility.
But how in the world is volatility an appropriate proxy of risk? Sure, it's convenient, but I find it incredibly hard to believe that such a measure can be of any long-term use. This measure of risk assumes that the historically-measured beta and alpha of an asset are a good predictor for the future beta and alpha, which seems absurd given how often the markets boom and crash in completely unpredictable ways. For instance, I'm sure the volatility in the market value of Lehman Brothers and Bear Sterns must've been relatively low in the years leading up to the 2007 financial crisis, yet certainly the actual risk of these two assets was enormous (but unknown, to most).
Surely, a more sensible way to think about risk must be in terms of what one knows and doesn't know about the asset in question. I.e., the real risk associated with an asset is all the unknowns. E.g. incorrect assumptions, the possibility of various unforeseen events and so on. Of course these things are difficult to quantify, but it must be better to deal with a non-quantitative measure of risk than dealing with a quantitative measure of risk that's incorrect. Right?
Or perhaps I'm misunderstanding something?
NO
may expand later but already written a lot today (not on WSO). my elevator pitch thoughts are
risk is a loss from which you cannot recover
I recommend nassim taleb and howard marks for how to think about this
the way many financial metrics are calculated are on shit math that may or may not happen in the real life and should be viewed VERY skeptically
the combination of relying on shit assumptions, hubris, and sometimes leverage has led to untold numbers of blowups and even more one trick ponies (or lottery ticket winners who continue to collect new aum...PAULSON)
Seth Klarman said it best:
"I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments.
The price level is also ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment than the same IBM at 100 dollars per share. Beta fails to allow for the influence that investors themselves can exert on the riskiness of their holdings through such efforts as proxy contests, shareholder resolutions, communications with management, or the ultimate purchase of sufficient stock to gain corporate control and with it direct access to underlying value.
Beta also assumes that the upside potential and downside risk of any investment are essentially equal, being simply a function of that investment's volatility compared with that of the market as a whole. This too is inconsistent with the world as we know it. The reality is that past security price volatility does not reliably predict future investment performance (or even future volatility) and therefore is a poor measure of risk."
I never understood these misconceived illustrations of risk and how some investors think about volatility in general.
Mr. Burry explained it best in one of his 2001 investor letters:
"And the better managers are conceived to achieve average returns while exhibiting below-average volatility. By this logic, however, a dollar selling for 50 cents one day, 60 cents the next day, and 40 cents the next somehow becomes worth less than a dollar selling for 50 cents all three days. I would argue that the ability to buy at 40 cents presents opportunity, not risk, and that the dollar is still worth a dollar...A wildly fluctuating dollar selling for 40 or 50 or 60 cents will always remain more attractive - and far less risky than a dollar that consistently sells at 1.1X face value".
The "riskiness" of an investment should be looked at on a per asset basis comparing the "quality" and the "price" that you have to pay. Characteristics such as illiquidity or volatility for that matter, do not quantify risk per se.
It's not a fair example because in this case the dollar that changes value each day has a predetermined outcome. So you would know at 40 cents that it is a buying opportunity because it only can go up from there. This assumption cannot be translated into real life. In real life, at the moment of purchasing at 40 cents, it is possible to go to the downside given the previous drop is 10 cents. Therefore, it cannot be said that wildly fluctuating dollar remains more attractive than a dollar consistently selling at 1.1X face value. Given that, I am not convinced that it is more attractive.
Without the entire context presented here as to what Mr Burry was referring to to the shareholder letter, what you quote could be literally interpreted as bitcoin and GME/AMC is more attractive than assets with a constant face value because it is wildly fluctuating. However, it may be the case your trying to refer to the same asset with different movements.
Further, looking at the quality and price of the asset to determine the riskiness of the investment is at best arbitrary because the "quality" and "price" is subjective. The assumptions behind your conviction could be drastically different from reality or the direction of the asset that it wishes to head. This means that what seems to be a quality pick for one may not be a quality pick for another
By looking at the past prices to understand the information made known about the perceived future outlook of the company (micro and macro factors), IMO, would be the prudent choice to invest and manage money.
I think you're missing the point here. Even if the 40 cents drops to 15 cents, but the underlying value is a dollar, it would present an enormous buying opportunity. Sure, in real life you don't get the exact face value of assets but that's why you have to properly value them. If you can buy an asset for 400 that is worth a 1000 according to your own valuation, it presents a good investment opportunity (assuming that you made a proper rough ballpark valuation). Even if the price drops first to 200 before climbing up again its still a good investment. You never know the right point of entry of any investment but as long as you are doing your valuation properly, buy at a discount, even the most volatile assets can be good investments.
And yes, even though I buy no coins myself (shame on me looking at everyone around me making easy money), bitcoin could still be a good investment if the value is indeed a multiple of what it's currently trading at. All I tried to make clear is that volatility is no right measurement of risk per se. I would rather buy an enormous volatile asset for 40c on the dollar than buying a dollar for a dollar which trades constantly at face value.
Sure, quality and price is subjective. But so are market prices and past prices (which you seem a big fan of). Volatility of stocks, and metrics such as systemic risk are at best nonsense as well. Market prices can be completely out of whack too. Have a look at the alchemy of finance by Soros which was mentioned up top to have a better understanding of what reflexivity can do to prices. I agree that past prices can be helpful in valuing assets, but only as long as these past prices refer to real underlying drivers of the asset. You can buy a stock assuming the volatility is low, looking at historic vol, but you can lose a lot of money if you the position moves against or if you get squeezed and if you did not buy at a proper discount. As long as you bought the asset for a discount, eventually you will come out of top again.
But anyways, whatever floats your boat and makes you money at the end of the day right.
I did a bunch of shit (research, work experience, clubs, pitches) around asset management (fundy/macro) and this is a no-brainer topic that I like to discuss:
Volatility =/= Risk
I don't care if an asset class is literally a 45 degree straight line but can tank 70% at the drop of a hat, I'd rather hold an asset that looks like a fucking rollercoaster but doesn't stay down for years on end if it plummets.
Two levels of risk for a PM (not fund):
1. The riskiness of an individual security
2. The combined risk of a portfolio of assets
A good PM will evaluate these two separately.
1. How much can I lose on this stock/bond/etc.? Historical variance/std is helpful to see how new information and uncertainty impacts the stock. Backing this into a fundamental model is useful to evaluate the outcomes investors were pricing. Is there a risk of permanent capital loss in this asset? If I need to quickly dump this asset, will I be able to do so easily? Etc.
2. What does my portfolio risk look like? Am I over/under exposed to factors? Are the risk characteristics in-line with my thinking? What does my drawdown look like in various scenarios (using beta as a proxy for risk here)? How is my covariance? Am I properly diversified across my themes/views, or is my entire portfolio simply one big bet?
Replying because edit doesn't seem to work...
Pure alpha strategies will try to reduce ALL non-view items. E.g. If I stress-test my portfolio with SPX/any benchmark at various levels, the impact to my PNL is 0.
Relative value strategies are "factor loaders" in that they are over/underweight some type of characteristic (value, growth etc.). Therefore, SPX scenarios should also have a negligible impact on PNL. However, factor indices or benchmarks should have an impact to pnl. E.g. if you're a value investor, it should mean that your beta to value factor is >1.
Tl;dr
Thoughtful risk management incorporates quantitative measures of risk with qualitative measures -- but those don't mean anything without context (which for a professional investor is their mandate). Bashing the usefulness of this stuff (and things like CAPM, EMH, etc.) is a great signal that you don't know what you're talking about, while simply regurgitating axioms fails to demonstrate your thoughtfulness. Strive for balance!
Depends on the duration of your liabilities man. For some people, the massive fluctuations are irrelevant.
If your dick tunneled through your thigh and tunneled out within a millisecond, it wouldn't matter as much as if they remained merged for a month.