Monday, November 3rd, 2014
the risk machine

While juicy returns will always cause the salivary glands of investors to water, these days the investment industry seems to talk more about risk than return.  No doubt the financial crisis played a role in bringing risk to the fore, but its journey to prominence has been decades in the making.

Thirty years ago, scatter plots of asset class forecasts (as well as those fancifully precise efficient frontiers) were charted with a Y-axis labeled “return” and an X-axis labeled “standard deviation.”  Over time, “volatility” replaced “standard deviation,” but in many of today’s versions, the X-axis is marked with a different, loaded, word:  “risk.”

That equivalency — risk equaling volatility — has become the foundation on which much of the modern investment industry rests.  There are some heretics, of course, who dispute the simplification that has occurred.

For example, Howard Marks kicked off a spirited debate about the issues with an article two months ago, “Risk Revisited.”Oaktree Capital | There are a number of other worthwhile pieces from Marks on the Oaktree website.  He started the piece by noting that he had previously “argued against the purported identity between volatility and risk,” seeing volatility as “the academic’s choice for defining and measuring risk,” which “falls far short as ‘the’ definition of risk.”

Its allure, Marks explained, is rooted in its “machinable” nature:  “volatility is quantifiable and thus usable in the calculations and models of modern finance theory.”

Therefore, an investment advisor can easily show a client how adding “alternative investments” will lower the risk in her portfolio.  The numbers take on the appearance of facts and the decision seems to make itself (which goes a long way to explaining the incredible gold rush into alternative products that is taking place right now).  The risk machine has been consulted; an answer has been given.

Similarly, institutional asset owners live in a world that is basically framed by one kind of risk.  They consider risk-adjusted performance measurementsthe research puzzle | The Sharpe ratio being the most misused, in my estimation. and portfolio risk budgets and risk-balanced strategies, probing that single dimension for all it is worth.  While other types of risk are discussed in passing, especially in relation to individual asset classes, volatility — or, rather, perceived volatility — drives the big decisions.

And it is distressingly common for the chief investment officer of a big pension plan to be quoted as saying, “These actions have reduced our risk,” when the moves have introduced significant risks of one kind or another, but the net result is that the risk machine spits out a lower estimate of overall volatility.  It is as if those in charge have a single, large dial, which can be ratcheted up or down, resulting in new mixtures of assets that can produce a desired level of risk.

Given his stature, it is reasonable to expect that Howard Marks’ memo would have been widely read, not just by his clients and other followers, but much more broadly, by the asset owners and asset managers and consultants and advisors who speak the lingua franca of the day and act in accordance with it.  But I bet hardly any changed their decision processes as a result.  The way of the world is just too entrenched right now.

Ironically, that may be the greatest risk of all.  Today’s risk machine won’t last forever.  Let’s hope the transition to a new model won’t be triggered by a cataclysmic failure of the one we have now.