The Anecdotal Risk: Why we need to think the way we are not today?

In my last post, I built up, slowly, the groundwork for a pathbreaking aspect of measuring and managing investment risk – the Portfolio theory of Harry Markowitz. Using a lot of mathematics, and an equal measure of common sense, Markowitz showed the expansive investment world that with effective diversification risk can be distributed if not minimized. To me, this theory, or even better, a particular aspect of this theory, which I will write about now, seems intriguing! What was actually playing in Markowitz’s mind (besides what he constructed the theory for!) other than a ‘diversification of assets’ that would chase away, or keep at bay, the most ‘irritating’ aspect of a risk manager’s life – that volatility (standard deviation with respect to mean)? Does he also say that by resorting to diversification, the investor is maximizing ‘returns’ (minimizing risks), which obviously is his goal? For this categorical answer, we need to take a look at multiple angles, and lit Markowitz’s theory up in conjunction with some other pioneering works in the field.

I will slightly deviate today from the usual approach my readers are familiar with. I usually favor constructing a story, plot by plot, and then bridge those plots into a platform that holds the grand finale! I find this way easier for me to tell a story, in my own simple way, and equally easier for new and untrained readers who are assimilating them. I have made it, as an author, a point to make my readers think, rather than merely read. The deviation I am going to make today is equally interesting. I will talk about a theory/model in the beginning, deconstruct it elegantly, and go back to some fundamental questions that elicited them. I will also question today about the investment strategies that came out of these theories/models. As this page is devoted towards Risk, I will always write about it, keeping it as a principal component; while aspects of Finance and Investments will be placed secondarily even though the relevant theories may have had financial/investment leitmotifs.

The Capital Asset Pricing Model (CAPM): the pioneer of Market Risk

Look at this simple equation:

This very famous equation, known to you all as students and practitioners of Risk and Finance, as the Capital Asset Pricing Model or CAPM builds up a fundamental relationship between Expected Return and Risk. I have no intent to writing additionally on this well known work, or criticize; this being always at the forefront of financial texts and scholars’ debates (not any recent debate though), but, as my motive almost always is, pinpoint certain aspects of it that is so intricately interwoven with the evolvement of modern risk.

In layman’s language this model says,

As an investor you should ‘expect’ (watch the word expect here, denoted by E in the equation – doesn’t it sound probabilistic to you?) a return much higher than a risk free or a bank deposit return, if you can pump up the riskiness of the portfolio by managing the Greek letter Beta in the equation.

So the simplest denouement of the equational plot….

A portfolio should earn at least a risk free rate (a bank rate – sounds logical enough!), AND an incremental one when one is able to apply lever on this beta or the systematic risk that CANNOT be managed. Such risk needs ‘efficient’ diversification! Even beta will not be zero after an amazing diversification strategy executed.

Let me go a step deeper.

The English equivalent of the equation is,

An expected return is equal to the risk free return AND a market return over the risk free rate of return ADJUSTED by the BETA or the Systematic Risk factor. Simple enough, right?

Please bring back the memory of my previous discussion on Markowitz’s work! He spoke about diversification to weed out, or shall we say smooth out, this systematic risk (risk inherent therefore undiversifiable).

My next question is, how much diversification? Is there a way we could compute this beta that we are trying to minimize?

Let me give you the second answer first. There are methodologies to calculate the beta. So using that, we understand the extent of the ‘lever’ an investor needs to pull. Thus, a higher beta (naturally, meaning higher risk for this purpose) will have a higher propelling factor for the second part of the equation. If we keep on taking risk, the returns will go up. Can we, as Risk Managers, be so naively thinking?

Please note this Beta is a measure of sensitivity of the Portfolio, the investor or the investment manager trying to optimize. See here that I am no longer using the word maximize. It makes no sense anymore, at least as a diligent taker of Risk.

Markowitz was to the markets, what Isaac newton was to physics. Markowitz laid down a scientific path to understand Risk in investing. He said, using sophisticated math, that we have a problem statement in investing and that needs diversification. A diversified portfolio, at best, will negate variance and yield average returns over the long run. This is where Markowitz stopped and entered William Sharpe. I already stated his eponymous equation, the CAPM, that advanced Markowitz’s concept in an elegant format. But this is certainly not the end. I cannot say under any circumstances that CAPM is definitive and that elusive Beta solves all problems. At best, it looks at another angle of market risk measurement.

Let me digress here a bit. Think over this.

Harry Markowitz mathematically ‘proved’ that putting all your eggs in one basket is extremely risky. Warren Buffet does not believe in this. He believes that diversification makes no money in the long run, therefore, makes no sense. He would rather ‘buy’ a few things that is cheap (look at valuations coming into play here!) after knowing them really well. So information is the key here as well along with valuation. Where is the BETA then?

Paradoxical, isn’t it? A Nobel Prize winning concept versus a venerable, seasoned investor Guru, a doyen of the market who the world revers!

I once again welcome you to the world of Risk!! This strange contradiction!!

Here, we do follow models and build equations, yet do not trust them blindly. We trust, additionally, on deep knowledge and insights. Insights that are experiential, and they work like true beacons. When there are doubts, we rely on those self guided principles along with the mathematics that are, at best, indicative. In the real world of risk, remember always, use your own gut feeling and knowledge of the market. Study the behavior of the markets and economy in a diligent fashion. Critically study the current risk factors that affect the business and portfolios. Develop solutions that come out in synchronicity with the requirements, not what equations tell you to do.

I faced this dilemma myself during the 2008-9 financial crisis, when I was responsible for the credit exposures of a certain structured product portfolio(s) my firm was trading. I will talk about it when time comes.

Coming back to the CAPM now, we understand that this omnipotent ”beta” just cannot be used to ”diversify risk” and spruce up handsome returns. An excessive exposure to ”high beta” investments may actually ruin returns. So, as we touched upon this topic in my previous article, a careful balancing of portfolios is needed. It comprises of the correlation between assets and their constant dynamism. That’s the evolving principle I was talking about. The sensitivity of the portfolio, this beta that is somewhat akin to the ‘delta‘ in an option portfolio (I will discuss Option Risk in details later in this blog), that allows a market maker to hedge with offsetting positions on the underlying, therefore, is a tool to adjust the outcome of a decision taken and that decision is NOT DEPENDENT on the beta alone but a number of other factors, both economic and business!

Can we say then that what William Sharpe suggested (CAPM) along with John Lintner and Jack Treynor that risk-returns being so closely associated, an investor expects or needs a higher return due to assuming higher risks? This is a converse proof, right?

Isn’t this something investors are doing all along, since the start of the speculations??

Eugene Fama emphasized that markets follow random walk. All available information is priced in already by the market as well, and prices do not follow a past discernible pattern. If the markets are so perfect, why are there so much observable imperfections? Why are there arbitrage opportunities that players want to latch on to?

I am closing this discussion today by invoking a fascinating question in your minds. The entire premise of risk management stands on two basic things – the mean and the variance. The former is the average return and the latter is the variability. Standard deviation/variance measures this or volatility. For an investor, the wider this variability, or wilder the swings in price, the greater the risk. So risk is known, right?

What is unknown then? Give yourself some space and think….

The unknown is the degree of this ‘known’ risk. Things that have not happened, even in your imagination. To quote Sherlock Holmes again:

”There Watson, we go into the realms of the conjecture….”