Well, when it comes to risk measurement his line doesn't fit, as their are several definitions available. Leslie Rahl (of Capital Market Risk Advisers) has become somewhat famous for her long list of risks, which she further qualifies as being incomplete. There is no commonly used definition for risk, and perhaps this is how it should be. Risk is usually defined in four ways:
- Volatility
- Possibility of a loss
- Possibility of not meeting the client's objective
- Uncertainty.
The possibility of a loss and possibility of not meeting the objective can be measured using the same formula: Sortino ratio. We just adjust the absolute return in our equation, from zero (for a loss) to our goal, or minimal acceptable return (or, if you prefer, minimum funding ratio or liability related benchmark).
Uncertainty is difficult to measure. Scenario analysis can be used here, where we look at different possible future events to see how our portfolio would behave. Value at Risk and Liquidity Risk might also work, too.
Regardless of your definition, we see risk as something that needs to be "ganged up on." That is, approached from multiple angles to get a sense of what is really there. The old television game show, Concentration, might be a good metaphor for risk. We want to get a good look at what risk is, but must take several views to really understand it. But unlike the game show, it never fully reveals itself.
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Terrific post. This shapes the overall discussion of risk that is needed for both investment management and performance management. Each point on the list needs to be explored fully. For example, volatility isn't just the short term ups and downs of the market, measured by some average standard deviation. It's also the trend of that statistic, along with other categories of volatility, such as the "higher monments" of skewness and kurtosis, which are perhaps even more important to investors in terms of risk than simple volatility (which is something of a catch-all phrase.)
ReplyDeleteIs volatility a true measure of uncertainty? Maybe in some statistical sense, but I'm sure that there is more to than that for investors. The possibility of losses of certain magnitudes is perhaps the scariest type of risk to investors in the short term, while failing to meet their investment objectives is the longer term version of risk.
I think that getting the broader categories of risk is the most important aspect of real risk management, and perhaps you've done that in this posting. I'll bet that the myriad of risks you mentioned earlier can be fit into your framework. For example, reputation risk is an aspect of failing to meet your objectives, while a changing market environment is an aspect of uncertainty. While there may be an infinite variety of these "micro" risks, it's likely that we can manage them into a broader framework such as yours.
Steve, thanks for your comments. We could go on and on about this, and probably should!
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