Risk management is worth nothing when market participants act in panic

Dear reader

When have you risked something for the last time? I claim that every day we take risks and that is something positive. Risks keep us moving. I like the quote by Roman writer Seneca who said more or less that things sometimes seem difficult because we dare not venture.

However, as an investor, we do not like risks. On the contrary, we try to avoid them. That makes risk management a core element in every investment strategy.

We have invited Edwin Datson, a risk management specialist, for our 2-day-workshop (identical with the EMBA/EMSc module). It takes place on 09 and 10 of May (Friday/Saturday). Sign up!

In the following interview he speaks about risks, the methodology of risk management and what you should keep in mind whenever you deal with risks whatsoever.

I am looking forward to seeing you!
Peter Lorange
Peter Lorange, Lorange Institute of Business

 

 

Edwin, you are teaching a module called “risk management”. Behavioural finance specialist Jeffrey Satinover said that human unpredictability is the biggest risk whatsoever. Are you teaching how to minimize the love of risks?

Let me put it provocatively: I am sceptical of the ability to beat the market. There are people who tend to think they have a consistent edge over the market and that is a risky attitude. In more moderate words: the course is about asset and risk management.

So we are talking risk management within the context of financial assets. More than that we narrow our view on systematic risks, which is an obvious move because there are simply too many areas of non-systematic risks that will not be touched (supply chain dependence, brand impact, legislation, key person risk etc.). As a matter of fact, it is helpful as a manager to separate non-systematic risks from systematic ones like foreign exchange rates, commodity prices – even the weather can be a systematic risk.

“I am sceptical of the ability to beat the market.”

Summarized, our goal is that the participants get an ability to be objective and realistic about the range of outcomes that could occur. Evaluating the risks of the oil price requires a real long-term volatility, not only a year or so. We try to give the students an accurate understanding how to go from a theoretical portfolio to a real one and what the risks to a portfolio could be. To do so, processes are needed for the evaluation of different potential strategies (like costs, fees, correlations counterparty risk etc.).

Speaking about strategies of evaluation: almost 20 years ago, the insurance company “Zurich” developed a risk management methodology to evaluate whatever risks in five steps. Do you concur with such a model?

This is not a bad methodology but you have to keep in mind the key questions, which are always ‘what will happen’ and ‘how likely is something to happen’. The mistake most people make is that they overstress unlike risks. Take air travel. The idea of dying in a crash is a horrible scenario but the probability to die is very low.

Zurich risk MethodologyThat means the methodology is very much dependent on getting probabilities for unlikely events right. Further, If you miss the point about the correlation between these risks all your simply looking charts will come out terribly wrong.

To get things right or wrong is key for all parties involved but especially from an investor’s point of view. In his eyes, finance managers should learn how to be properly but not overly risk-averse. How can we manage risks, which are not perceptible (future turmoil etc.)?

In the recent crisis people have been hurt more than they should have been because of lazy portfolio construction. There may be global events that impact all asset classes, all countries, but some portfolios were massively less diversified and protected to future events than they could have been. Why? For reasons of comfort and in some cases for reasons of regulations. There is always a risk but also a range of appropriate solutions, which depend on the investor’s requirements like time horizon, income requirement and so on. The last few years have seen a huge increase in products which allow normal investors to get true global diversification cheaply and efficiently (such as index trackers) but many advisors have been slow to take advantage of them.

Bildschirmfoto 2013-09-26 um 14.20.04“Liberty leading the People” by Eugène DelacroixA masterpiece – but riots are not a climat favouring investments.

If risk is inherent, the key is not to avoid it, but to quantify it properly. How would you do this? 

Crudely, you can get a handle on the level of risk or potential volatility in two ways: first, you can look back at how the price of the asset or commodity has behaved in the past. The second way is to look forward: if the asset is traded, you can see from the cost of options what level of volatility the market thinks is likely to occur. Since this number reflects the opinion of all expert traders in the asset, it is a pretty good starting point. As an example, let’s take a company which makes plastic components. It is exposed to oil prices. How big is that risk in reality? Any manager would look back to the development of commodity prices, but the question is: how long do you look back? So, time is important. You need good data and therefore I recommend using a decent time period when you think about potential movements.

“You cannot argue about stock market growth without considering that the Russian and the German stock markets (which were strong and significant in the early 1900s) went to zero in the last century.”

The whole cycle should be considered, ideally across many cycles. For example, many equity analysts were arguing for very low equity premia, but if you take US public equities 2001-2006, you get very different answers than if you consider all stock markets from 1900 to 2006. So, besides of good data you should also avoid common traps like survivor bias, which is a behaviour that leads to overly optimistic beliefs because failures are ignored. You cannot argue about stock market growth without considering that the Russian and the German stock markets (which were strong and significant in the early 1900s) went to zero in the last century.

The second method would involve looking at the implied volatility on options in oil which are for the same time period you’re interested in.

A final point to consider is the correlation between risks. Things are linked and yet not completely dependent, for example the stock markets in the United States and Switzerland. These correlations need to be calculated carefully. And finally, you should recognize how relationships can change. In normal times stocks and bonds work differently, say stocks go up, bonds and interests go down. But what happened during the crisis? Everything went down due to fundamental concerns about the viability of the system.

So, risks can be quantified but in finance the best risk management is worth nothing when market participants act in panic. Which are the core pillars of risk management in modern banking?

That’s too broad to be answered in detail and as a specialist subject we won’t neither attempt to cover it properly. Broadly, I think the financial crisis highlighted a few critical points: although all the banks had sophisticated value at risk models to monitor risk, losses were way higher than predicted. This was due both to the inputs on likely volatility being too optimistic but also, crucially, the correlations and links between assets did not seem to have been modelled properly.

Organisational structure can also influence risk management; departmental silos can make it hard to see systematic risks across the whole bank and can make it hard to disseminate the best expertise across all departments. For example, the bank’s internal real estate funds were far more nervous about the mortgage backed assets than other departments who may have relied more on the externally granted credit ratings when assessing risk of securitized mortgages.

Finally, which is the core element in your module at the Lorange Institute? 

Fear and greed, like the saying from Wall Street that the market has only these two emotions. (laughs) I always tell people that they should not try to be smarter than the market and be sceptical about those who say they are. But you should all the same be firm in seeking the most efficient strategy because most investors never have a realistic chance of getting a decent return for their risks because of inefficient and expensive products. (due to high fees, high churn, weak diversification). I eventually want the participants to have the necessary open-mindedness to think broadly and creatively about sources, scales of risks a how assets are connected and how that could change in the future.

Who is Edwin Datson?

Edwin Datson Risk Management Specialist at the Lorange Institute of BusinessHe currently runs a risk consultancy advising corporate clients on managing market risk. He is also an advisor to Arts Alliance, a European Venture Capital Fund specializing in digital media. Prior to this, he founded and was the portfolio manager of Wolf Rock Capital, a European equity long-short fund. Prior to Wolf Rock, he worked in public equity at Cycladic Capital. He spent three years in private equity as a Principal at Bain Capital Europe where he worked on leveraged transactions in several industries. Before Bain Capital, Edwin ran a group at Morgan Stanley responsible for generating and executing leveraged buyouts. Prior to that, he spent five years in strategy consulting with Monitor Company in Europe and the US.

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