One of the highlights for me in 2011 was when I got invited to speak at a leading university on the financial crisis. This university is home to some of the most well known and influential economists.
The topic I planned to speak on is the fatal separation between academic theory and real world practice in markets. The notion of risk is certainly at heart of this, Pat Dorsey recently wrote an insightful piece on this point
Stipp: You wrote recently a little bit about risk, and you mentioned that a lot of different people have a lot of different perceptions of risk. Can you walk through what different things risk means to different types of investors?
Dorsey: This is a little bit like discussing the existence of God with a theologian. An academic says risk is volatility--the more an asset bounces around in price, the riskier it is.
A mutual fund manager might say it's career risk. If he lags his benchmark for too long, he gets fired.
An individual might frame it as pain. Of course, we feel losses much more than we value gains. So just seeing your portfolio go down is a lot of risk.
And of course Warren Buffett would just define it as permanent capital impairment--the odds that an asset's value will go down and never recover.
Those are pretty different notions.
In my view, these varying definitions of risk are at the heart of what we saw in 2008. In particular, academic models of risk as volatility were hard wired into trading algorithms, and then further juiced by leverage (up 30x-40x leverage!). The risk as volatility assumption by itself would have just led to dumb trades and losses. But with the extra weight and status of the false precision that academic models can provide, this gave large institutions the courage to lever up 40 to 1 and this turned bad trades into catastrophes and meltdowns. Overconfidence in what one could count and ignoring what one couldn't model.
Howard Marks, The Most Important Thing
"According to the academicians who developed capital market theory, risk equals volatility, because volatility indicates the unreliability of an investment. I take great issue with this definition of risk.
It’s my view that — knowingly or unknowingly — academicians settled on volatility as the proxy for risk as a matter of convenience. They needed a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risk do not. The problem with all of this, however, is that I just don’t think volatility is the risk most investors care about.
There are many kinds of risk. . . . But volatility may be the least relevant of them all. Theory says investors demand more return from investments that are more volatile. But for the market to set the prices for investments such that more volatile investments will appear likely to produce higher returns, there have to be people demanding that relationship, and I haven’t met them yet. I’ve never heard anyone at Oaktree — or anywhere else, for that matter — say, “I won’t buy it, because its price might show big fluctuations,” or “I won’t buy it, because it might have a down quarter.” Thus, it’s hard for me to believe volatility is the risk investors factor in when setting prices and prospective returns.
Rather than volatility, I think people decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return. To me, “I need more upside potential because I’m afraid I could lose money” makes an awful lot more sense than “I need more upside potential because I’m afraid the price may fluctuate.” No, I’m sure “risk” is — first and foremost — the likelihood of losing money."
In obsessing over volatility and price movements, the Efficient Market Theory models missed human behavior in markets (driven by fear and greed), the safety of an asset, the liquidity of an asset in the face of certain events, and an overall conservative approach to investing - try to buy dollars for 50 cents, and not lever up 40 to 1 to buy many $100 bills for 99.95 each. This, of course, goes to the heart of risk management - namely building a wide margin of safety as a hedge against your own ignorance, instead overconfidence in flawed models.
Hedging against your ignorance up front (usually by paying a cheap price) means that you have more time and resources to spend on constructing a margin of safety to protect assets and ensure they are there when you need them. Ill placed confidence in risk models like Value at Risk (VaR) instead of conservative process led people to ignore these two virtues. When events began to unwind the dominoes fell quickly because there were no buffers and no foundation just algorithms gone wild.
I never gave the talk. So what was the highlight you ask? A week after the invitation came, and was ready to talk on the fatal separation of risk theory and practice, I was disinvited for not having a PhD! I often wonder what was discussed in those sessions.
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