Back in the day when all of the CFA exams were made up of essay questions, I would encourage those taking the tests to imagine “risk” written on the back of one hand and “return” on the other, so that they would remember to have their answers reflect both aspects of each question.  They go together.

In fact, much of the time they are viewed in simple ways, with “risk” equaling the “volatility” of those returns and a normal distribution presumed, perfect for efficient frontier analyses and the like.  That is certainly one way to look at risk — and is worth considering in an attempt to understand all elements of the market riddle  — but it is not among the three types referenced in this posting’s title.

Investment risk encompasses all different sorts of things, depending on the asset class and the security structures that are owned.  Fixed income investors obviously take on interest rate risk to varying degrees depending on the bonds they hold, but so do equity investors.  Political risk used to seem more the province of those dabbling in the emerging markets, but it’s inescapably everywhere these days.  A list of risks can be sorted and divided in many different ways, but it’s not hard to come up with fifteen or twenty species for evaluation.  Do you have a good understanding of which risks you are taking on and how you are being compensated for them?  It seems to me that that is a better question to ask than what the historical volatility of an instrument has been, since it helps you to think about “why” and “what may be.”

In looking at the components of risk in this way, it’s also easy to see that many of these risks are not normally distributed.  The products of the securitization boom are particularly good examples; their behavior in the last eighteen months could not be described as normal, statistically or otherwise.  We have also seen that counterparty and liquidity risks can go from forgotten to all-consuming in the blink of an eye.the research puzzle | In a posting last fall, I wrote about the “nasty habit” of liquidity disappearing overnight.

Behavioral risk is similarly complex, with some readily observable general tendencies (such as extrapolation) incontrovertibly an important part of market action.  The experts in the field have carved up and codified the errors into another long list.  The whole endeavor appeals to me because I can recount example after observed example of those risks overwhelming the investment risks along the path from conception to reality — and I know the value of building feedback loops that minimize the number of errors and mitigate their effects.

While the first two types affect investors no matter if they are at a large firm or day trading in their bathrobe in the basement, the third, business risk, relates to investment organizations and distorts their decision making processes.  Jeremy Grantham is a keen observer of these dynamics,GMO | “Reinvesting When Terrified” is a recent example of his writing on the subject. the lead sentence on a promotional email for his presentation to the CFA Society of Chicago being a short and sweet summary of the core issue:  “The investment management industry’s prime motivation is to stay employed!”  When that motivation kicks in, it can exacerbate the behavioral tendencies and overwhelm the careful assessment and pricing of the investment risks.

For those managing funds for others, escaping the gravitational pull that bends investment decisions into business ones is hard but required work.  For those investing in managed products, improved manager selection will result from an understanding of the investment exposures created by the collision of these three types of risk.  The clues are everywhere if you are willing to look beyond the published summaries of risk and return.