Friday, September 18, 2009

Risk without consequences

President Obama spoke this week regarding the improving mood on Wall Street and offered that “Those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall.” I'm not quite sure what this means. Risk always comes with consequences. Granted, having the American taxpayer bail them out isn't necessarily something one should take for granted, but if the United States is going to continue to grow, risks must be taken, yes?

In the current issue of The New York Times, Andrew Sorkin speaks about risk and offered that "Perhaps the greatest measure of risk — and in this context, let’s define it as systemic risk to the entire system — is one word: leverage." Perhaps I'm thinking too semantically, but I wouldn't characterize "leverage" as a "measure of risk," let alone the "greatest measure of risk."

And while I challenge some of what Sorkin offers, his thoughts on VaR are, as the Brits say, "spot on": "VAR, by the way, is a horrible way to measure risk, as has been said again and again by economists, because it calculates the risk for only 99 percent of the time. As Mr. Johnson [a professor at MIT's Sloan School of Management] says, “VAR misses everything that matters when it matters.” Indeed, the VAR metrics obviously missed what led to what now has been dubbed the Great Recession."

It's good to see that VaR continues to be scrutinized, even while it continues to be measured and reported: I guess some folks that any number is better than no number, but understanding the number, what it means, and its reliability are probably critically important aspects of any risk assessment. I will be addressing the pros and cons of risk in an upcoming NYSSA journal article.


  1. It makes no sense to discuss risk measures when the basic data you're analyzing is wrong. We need to get the basic data right before we worry about elegant ways to analyze that data. Just look at the gross mis-statements from these quoted "authorities" who think that the recent recession (at least in terms of securities returns) was the greatest recession we have seen. They are wrong! A quick glimpse at the historical data shows that the downturn of the mid to late 1970s was much worse. Why the differences in perspective? Because the "Great Recession" guys are ignoring inflation! Does inflation matter? Well, does how much your money buys matter? I think it does.

    When you take inflation into consideration, the losses in the mid 1970s were WORSE than even those of the Great Depression. And the recent losses were not as bad as either of these. Here are some facts: In the Depression, the worst 5-year real return on the S&P500 was -32.1% at 1932. The 5-year real return of the S&P 500 in 1974 was -35.5% while the 5-year real return of the S&P 500 in 2008 was -21.5%. What a difference REAL data makes!

    So, let's take the long view and let's remember that we should use real returns in ALL of our analysis. Then let's try to get our arms around risk as best we can.

  2. I do agree but find it difficult to understand the meaning of REAL data. Using the "Total Return vs. NAV return" discussion as a starting point, there are lots of way to represent returns. Which method/type return series to use that would truly make our analysis better than others, or the authorities?

    You stated REAL return; I believe you mean total return divided by an inflation adjusted number/data (either real or nominal GDP..ect). Assuming I'm correct with the denominator, what such we use for the numerator?

    1) If I use gross return for the numerator, knowing that I never will earned gross returns, is the data meaningful?
    2) If I use net return for the numerator, knowing that I will earn this in my portfolio by my management fee could skew the results, is the data meaningful?
    3) If I use price return series for the numerator, with missing dividend / income information and knowing that this is not my true earnings, is the data meaningful?

    Each one listed above and including other methods could change the results. Any opinion is greatly appreciated.

  3. In regard to the question of what REAL data means: It is an industry convention to use a total return (income return plus price return) as the so-called "nominal return" of an investment. This is true regardless of the type of investment. This provides a consistent definition that allows the various market segments to be compared in terms of return and risk. The inflation adjusted return is calculated as the ratio of the "return relatives" or (1 + total nominal return) divided by (1 + inflation) and then subtracting 1. It is NOT an industry convention to break up the components of real return into a price component and an income component.

    And, this was not the focus of my comment regarding the necessity of real returns. Neither was I commenting on the nuances of NAV return. Rather, I am pointing out that many commentators have overstated the depth of the recent/current global recession and the resulting losses in the securities markets. The reason they have done so is because they are failing to consider the impact of inflation, and because they continue to follow an industry convention of using nominal, non-inflation adjusted returns instead of the more meaningful real, inflation-adjusted returns.

    We can easily see that returns during the Depression were not as bad as reported because inflation was actually negative during that time, causing the value of money to actually rise and therefore providing greater purchasing power. This helped to offset some portion of the losses on investments. Conversely, during the 1970s inflation hit historic levels - in three of the years it was as high as 12% and 13%. This doubling of prices had a devastating effect on investor wealth in the decade ending 1979. In contrast, the so-called "Great Depression" saw a decline in inflation of almost 20%, which actually helped to lessen the impact of the losses in the U.S. equity market.

    If we compare the results we can easily see that inflation really matters. For the decade ending 1930 the real cumulative return on the S&P 500 was +22% (yes, that is truly a positive number.) The real cumulative return on the S&P 500 for the decade ending 1979 was -13%.) What a difference inflation makes! My message is a simple one: use REAL data for investment analysis and for performance analysis because investing is meant to help investors growth their WEALTH, which is defined as PURCHASING POWER and not simply PAPER MONEY. Only real data allows us to evaluate the true performance of investments.

  4. My earlier comment has an incorrect date. In the last paragraph, the second sentence should read "For the decade ending 1939" rather than 1930. That is, the decade of the 1930s earned a real cumulative return of 22% on the S&P 500.

  5. Thanks for the clarificaiton. The reason I threw the question is because someone once said to me, "we try to find the longest set of data avaialble for our analysis. Total return is truly the prefer data set, but that information may not be available most of the time. I believe the only public available equity index during the early 19 century was the Dow and was created using price. Around the middle of the century, S&P came alone and then Russell. I just want to read your point of view on this matter.

    I also agree with your definition of wealth (I still prefer just market value). In the asset management business where sucess is measured by excess performance, besides risk adjusted returns, maybe GIPS should have a statement recommending to include inflation-adjusted returns and excess returns as well.


Note: Only a member of this blog may post a comment.