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? 

Comments (69)

Nov 29, 2021 - 3:50pm

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)

Nov 29, 2021 - 4:05pm

What you're saying makes perfect sense, and thanks for the author reccommendations. I'm glad to hear that many in the industry have a nuanced understanding of risk that goes beyond simple financial metrics. Would it be possible for you to name the institutional investors (hedge funds, prop traders, etc.) that rely on fake math and rubbish assumptions, and those that don't?

Nov 29, 2021 - 6:38pm

Sick, I'll make sure to read Taleb and Soros, thanks. Btw, since you're in the industry, could you reccommend funds that don't use simplistic models borne out of financial theory? I heard for instance that AQR is pretty bad on that. 

Nov 29, 2021 - 7:36pm

Almost all of the mid-small size quant shops use much more heavy methods with much weaker assumptions needed. Simplicity is still useful in many tasks (ie linear regression can still make money in the right context), but the people who do well have fully embraced modern ML techniques. Many of the larger boys do it as well, but not all (see dino's like AQR)

"one for the money two for the better green 3 4-methylenedioxymethamphetamine" - M.F. Doom

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Nov 29, 2021 - 9:14pm

Thanks, mate! It increasingly looks like to me that a minor fund ala Qube-RT might be a better fit than a major one like Citadel. I'd guess what matters most in this business is thinking in unique and different ways.

Most Helpful
  • PM in HF - Other
Nov 29, 2021 - 9:40pm

Responding here since you asked above as well. Truly as someone coming from a "physics" background I thought you would like "Soros" more since he talks about a portfolio as philosophy but also a quantifiable science. In terms who thinks/does not think, really it depends on your interest and where you think you can find alpha in finance. Is it solely on the basis of seeing different patterns, is it in the roots of equity analysis, is it in connecting data sets to real world outcomes just a few examples.

I would not write off any funds there is lots of people at a firm like Citadel that build and think about models the same way you do. There is also some people who will use var and high level metrics as their sole belief. 

But as many of us have mentioned, while academia is around var and the risk reporting team may use var. Majority of PMs and leaders think of "drawdown risk" which is sort of what described for some through many years of experience their gut can tell them on minimal data for others the reliance on in depth mathematical allows them the comfort do so. 

Dec 1, 2021 - 1:55pm

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."

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Nov 29, 2021 - 11:29am

I've had the same view for a long time. People look at volatility because it's easy to measure, but what they are really interested in is the maximum drawdown and chance of a permanent loss. For many assets, that tail risk also tends to be negatively correlated with the day-to-day volatility.

Nov 29, 2021 - 12:34pm

Yeah, you're right, it makes intuitive sense to me that the more you engineer your portfolio to eliminate volatility, the higher your risk of a blow-up. My reasoning is twofold. Firstly, portfolio engineering requires the use of leverage, and the more you leverage yourself, the more sensitive and vulnerable you become to market swings. Secondly, the more complicated the composition of your portfolio (just imagine adding derivatives, shorts, etc.), the more ways for things to go wrong in case the market conditions shift and break your assumptions. And markets are a well known chaotic, nonstationary and highly unpredictable system... 

This whole financial engineering business makes no sense to me (though it might be because I'm new). Why do hedge funds bother engaging in it? To impress potential investors with how fancy their maths are and thus grow AUM? 

Nov 29, 2021 - 6:48pm

They're making a ton of money, irregardless of whether you or I can understand it.

As for the engineering aspects, the math is obviously wildly complex but that's why they hire Masters and PHDs from Ivy League schools to do it. As for the assumptions, usually if the assumptions shift, the positions shift (look at high frequency trading as an example). 

Array

Nov 29, 2021 - 4:19pm

I had a super day at a LO 15 billion AM and answered this wrong. When asked how I measured risk, I discussed Beta, standard deviation, VaR, down Vol, etc. He informed me that the firm and him (PM) do not use beta and volatility at all. They are only concerned with permanent lost of capital. How this is measured is beyond my paygrade.

Dec 1, 2021 - 2:08pm

Purple9988

 They are only concerned with permanent lost of capital. How this is measured is beyond my paygrade.

That's the trick isn't it? How do you calculate the odds you will make/lose money on an investment, and to what degree?

If you can accurately measure risk in the financial markets, you can get rich beyond your wildest dreams. 

cc: thebrofessor 

Dec 1, 2021 - 4:56pm

it can be measured if your realized return is -100%

/snark

in all seriousness the likelihood you experience a total loss is probably incalculable, but there are a few ways to think about it

1. don't use leverage or unhedged shorting equities, minimizing the probability that temporary movements can give you a total loss

2. ensuring you have collateral/recourse if you're on the fixed income side

3. buying into ridiculously overpriced names (e.g. CSCO in March 2000, while it still exists it's showing a negative return 21+ years later, not a permanent loss, but close enough)

4. don't make your returns rely on assumptions spit out by models a la LTCM

5. avoiding things that sound too good to be true (like 15% investor returns on senior secured loans/whatever's being pitched to me today that I scoff at)

6. diversification minimizes the probability that one bad idea tanks the whole portfolio

7. tail risk hedging - taleb/spitznagel's strategy which is basically S&P 500 index + deeeeeeeep OTM puts for super cheap. managed properly this seems to be the easiest (although option trading isn't easy) solution, however since neither one of them offer any fucking hints as to how an individual investor can do this, I can't recommend it. 

sidebar: I've been wanting to have a discussion on tail risk hedging and the applicability for the little guy, but wonder if anyone would have any interest since it's so niche. part of my beef with taleb (FD: he's my favorite author, but like everyone he's imperfect) and spitznagel is they call foul on all of these parts of the financial markets (risk measurement being one of them) and then NEVER EVER offer a solution. when pressed, spitz says he won't give it away, so it's basically like "haha individual investors, everything you know is wrong and there's nothing you can do about it!" which isn't all that helpful unless you have $100mm (their minimum, I've called)

I've seen a couple of blowups from where I sit and thankfully have avoided them for my clients by and large (or if they've suffered, it's been a forgettable % of their folio)

1. concentration in a single named stock that never recovered (ORCL, C, CSCO, GE, worldcom/MCI, and more)

2. leverage, whether it's a private credit deal that lends $6 for every $1, 200% long hedge funds trying to play the momentum game, LBOs when a recession hits, or people doing cash out refis and buying the bitcoins and NFTs of yesteryear, and so on

3. speculation, be it land, real estate, commodities, options (particularly naked puts, short calls, etc.), home flipping when you have no clue what you're doing

Nov 29, 2021 - 4:38pm

Expected return per unit of standard deviation (or volatility) is fine for most people's understanding of the underlying math and financial risk. You're correct that it's fundamentally not real, but no model is.

I'd argue the bigger issue is relying on probabilities based on an assumed Gaussian distribution. This is empirically wrong and meaningfully undercounts tail risk, as others like Taleb have pointed out. 

Nov 29, 2021 - 5:20pm

Apart from Gaussian returns, there is also the dependency in tail events that cannot be measured. Assets and factors that look uncorrelated in normal times don't stay that way in big crashes, like March 2020. I guess people are aware of this but think it's too high a cost to hedge against everything, and just hope something really bad doesn't happen (or hope the Fed bails everyone out).

Dec 1, 2021 - 1:49pm

Great point, perfect example of this is the peanut industry. You'd think it would be a fairly consistent consumer staples play to hedge risk, but turns out it's highly correlated to airline performance and TANKS in a pandemic.

Nov 29, 2021 - 6:40pm

You send it to a quant to work on fitting an appropriate (sometimes custom) distribution when you see via graphs that normal distribution is ridiculous. 

How they do it... no idea lol

Array

Nov 29, 2021 - 6:37pm

Sure volatility can be bad but it also means higher return. I would measure risk by knowing expected returns given different probabilities

Technically it's the same thing, because an assumption that basic valuation uses is that returns follow a normal distribution so having a mean return and standard deviation of returns would be "enough" to reverse engineer what you are saying.

Obviously the normal distribution assumption doesn't hold out all the time, and when it doesn't you ask the quants to figure it out lol.  

Array

Nov 29, 2021 - 6:46pm

CAPM is extremely outdated. It "works" for instances where ballpark valuations are enough like pricing shares for an IPO. 

For investing, firms use a variety of metrics to price returns. These are proprietary and will vary from firm to firm.

For an example, you can look at a publicly released example in academia - Carhart four-factor model which uses factors that are dependent on the company itself, rather than just the variability of returns to predict future performance

https://en.wikipedia.org/wiki/Carhart_four-factor_model

Array

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Nov 29, 2021 - 9:43pm

Hi there, to directly answer your question and not go on a long tangent about the conundrums of finance... Risk is the quantity of possible outcomes. Something high risk has many significantly different outcomes, while something with no risk, has only 1 guaranteed outcome. Think A to B as a final end point without time as a variable. The token example for this is treasuries... but they do have duration and rate risk. Volatility on the other hand, while similar, is the what happens in between point A and B, and is an attempt to measure it. Usually models do a decent job of predicting this during "normal times".. but it's the outliers where things get interesting.

Side note, most intelligent and insightful person I work with has a physics phd background, I applaud you for making the switch and wish you luck on the journey. 

Nov 29, 2021 - 10:47pm

Indeed, it makes good sense that risk can be understood as the set of possible negative outcomes multiplied by the $-loss associated with each of these outcomes. And indeed the historic volatility can be used to provide a measure on the historic risk, and furthermore, it seems reasonable that sometimes the volatility of an asset stays roughly the same during "normal" times" and that this can be inserted into models to earn money. However, the moment these "normal times" end, I suspect things can quickly turn ugly, maybe even so ugly that the previous profits get wiped out... You see what I mean? And I think referring to these events as outliers is a bit suspect, as that implies outcomes in finance are concentrated around some mean, while in reality they are typically fat-tailed. Do the longest-living funds really rely on using these models?

Thanks a lot for your kind words!

Nov 29, 2021 - 11:11pm

Couple of points...
i) risk also applies to positive outcomes. Risk as generally measured today applies to both left and right tails of returns. 
ii) I might be wrong, but I don't think historic vol can be used to measure historic risk, at least not accurately.. You can look at how an ice cube melted, but you cant infer what the original cube looked like only seeing the puddle. It's two different pieces of information. Someone correct me if I'm wrong, this could be a shit analogy.
iii) Yes, I get what you mean, left tails (or the lack thereof) are what make or break you. It's what previous posters have referred to as drawdown risk / value at risk / left tail / etc, what happens when shit hits the fan. Normal times do end spontaneously and it is incredibly challenging to predict when this might occur. This is the whole premise of Taleb's book, The Black Swan. 

iv) As you state, returns are left skewed. That being said, returns do cluster around the mean. With this, it is fair to still call these events outliers. Looking at graphed data, they certainly are.. they just happen more frequently than models predict.. but that's why everyone is trying to build a better wheel. 

v) regarding long-living funds. I haven't been in the game long enough to know. I assume though the managers in these seats are prudent to mitigate left tail risk. That being said, given there have been so many 1,000's of funds created and investors... some will get lucky, others will not... and maybe thats all we're left with today. 

Nov 29, 2021 - 10:09pm

You're completely right. a big part of risk management doesn't really exist to manage risk, but to give the appearance that they're on top of risks.

Taleb is a bit of an asshole, but his POV on risk, volatility andrandomness is really interesting, I recommend you read his books, it will probably connect a lot more with you.

Nov 30, 2021 - 2:40am

Not a STEM student and I am lost in your train of thought, I would think volatility is an approximate of risk because of Efficient Market Hypothesis? Theres empirical studies that suggests that the US markets seems to be semi-strong so whatever public information (macro and micro) available would have reflected in the share price. So like for your example, Bear Sterns actually has been on a downward trend before it went bankrupt because the market is starting to price in the possibility of financial distress of Bear Sterns given the interest rate hike? I mean in the event it is going through imminent bankruptcy, anybody with a modicum of sense would recognise that the equity is worthless rather than the risk is the past volatility, no? Given that, past volatility is an approximate estimate of risk?

The larger the variance just means that the stock or the asset in question is more volatile, not that it would necessarily appreciate faster relative to the market.

Portfolio risk is different from volatility because it depends on the correlation of the assets as well. In your example, the HF or buy-side in question could have bought multiple assets classes with low variance and levered up but they have low to negative correlation with each other. Therefore, the overall portfolio risk is lower than purchasing an individual asset with low variance and levered up.

Nov 30, 2021 - 4:44am

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. 

Nov 30, 2021 - 8:11am

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.

Nov 30, 2021 - 8:32am

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. 

Nov 30, 2021 - 3:37pm

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.

Nov 30, 2021 - 5:57pm

Completely agree with you.

I'd say true risk is the variance of the distribution of the intrinsic value of a stock more than the volatility of the market price. The problem is that this distribution cannot be known with certainty in advance and we can only see the one realization of the outcome. 

That's why risk management should be something that is done by PM when constructing their portfolio and not something that is outsourced to "risk managers" who are focused on meaningless metrics in their spreadsheet. You need to actually understand the stock and the thesis to manage risks.

  • Analyst 2 in Consulting
Dec 9, 2021 - 7:54pm

Man I've worked on the quant side and the fundamental side, and I firmly believe that anyone who claims volatility =/= risk doesn't know what they're talking about.

Not that they're necessarily wrong, just that if this is something someone casually brings up in conversations they're about 2/10s of the way through Dunning Kruger.

Dec 1, 2021 - 1:17pm

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?

Dec 1, 2021 - 1:21pm

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!

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