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Risk management is a concept that surprisingly few investors spend time to understand. This is unfortunate. The paradigm of effective investing rests upon the idea that investors look at the expected returns from an investment compared to the potential risks. Investors try to get as much expected return as they can for bearing a certain level of risk. Along with this, investors must determine how much risk they can or should take on. How can investors rationally weigh potential gains against risks if they have no way to estimate risks? Most investors have some way that they estimate the potential returns—whether it is fundamental analysis, analyst price targets, etc. It is the rare investor who has any way to consistently estimate risk, however—either in individual holdings or in the total portfolio. This situation is somewhat absurd. 

It has been twelve years since a group of influential economists (including Nobel Laureate Bill Sharpe) lobbied (unsuccessfully) for the need for improved risk information for investors in mutual funds. Needless to say, the push for understanding risk gets muted when the market is going up—but it is my hope that this most recent market downturn will have the silver lining of focusing attention on the need for improved risk management for all investors—and not the just the large institutions that are the predominant users today.

RiskMetrics (RMG) is a company that I thoroughly admire (though I never invest in stocks with such rich valuations), so I was happy to see the firm profiled recently in Forbes. This is a company that has created a robust and wide reaching brand among financial firms. RiskMetrics is a pioneer in quantitative risk management tools for institutions, and their market share shows it.  I wanted to discuss the article in Forbes and the comments of its CEO, Ethan Berman, for a number of reasons. Most investors and wealth managers don’t know much about the modern practice of risk management, as embodied in the products that RiskMetrics sells. Even if you never use their tools or data, however, their perspective is valuable in understanding how institutions manage risk. I believe that investors and wealth managers will benefit by developing an acquaintance with risk management—this was one of the main reasons why I created Quantext Portfolio Planner [QPP]. RiskMetrics has also attempted to serve the individual investor by creating RiskGrades (www.Riskgrades.com), a site that brings risk measures to individual investors and advisors.

Before we go into a discussion of risk management, I feel compelled to deal with one of the common refrains about the problems with risk analysis. One of Mr. Berman’s key points in the Forbes article is that the current financial crisis is not the fault of the risk models, but rather of perverse incentives to traders to take enormous risks. This was precisely the theme of a recent article of mine---the interested reader should go to that article for more details. 

One example of the ability to calculate risks associated with individual stocks is RiskMetrics’ claim that their RiskGrades model showed that the risk associated with AIG doubled in the month through early August, to reach a projected risk level of five times that of the S&P500 (this was back when the stock was trading at $24). I used exactly the same example of AIG in the article in Footnote 4---I used Quantext Portfolio Planner to project the risk for AIG as of 6/1/2008 (when the stock was still trading at $36) and showed that the projected risk associated with AIG had increased dramatically from the end of 2007 through May of 2008. It was not hard to calculate this massive escalation in risk, using standard modeling techniques. As of this writing, AIG is trading in the range of $2.30 or less.

Let’s look at some more examples. In the Forbes article, there is a list of stocks that RiskGrades assigned a low risk and a list of stocks that RiskGrades assigned a high risk. The article cites data through September 18, so I ran QPP using data through August 31 for comparison—I prefer full calendar months for analysis. The results are shown below, along with the returns for each of these stocks from September 19, 2008 through October 17, 2008 (I am writing this as of October 18).

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I have maintained the ordering in the table from Forbes—the five stocks with the lowest RiskGrades (lowest risk) are in the top section of the table and the five stocks with the highest RiskGrades (highest risk) are in the bottom section. QPP’s projections use all default settings and three years of data as input (through August 31, 2008). The correspondence between QPP’s projected risk levels and those from RiskGrades is high. There is an 88% correlation between the QPP projected risk levels and the RiskGrades risk levels cited in the Forbes article.   It is also notable that QPP’s calculations would not re-assign any of the stocks from the high RiskGrades group to the low RiskGrades group (or vice versa). That said, the QPP projected risk levels are almost uniformly higher, with a couple of exceptions. In the “low RiskGrades” grouping, in particular, QPP projected higher loss potential. 

A compact way to summarize the results is to average them (see table below)—and the agreement is even more evident.

The algorithms that drive QPP have no relation to those that drive RiskGrades other than standards of practice in risk modeling. The strong correspondence between these results serves to highlight the fact that there are standard methods in risk management. This is reassuring. There are, obviously, some differences in these results. RiskGrades suggests that SPG is almost three times as risky as WPI, whereas QPP suggests that these two stocks have almost identical risk levels. The key take away is not the specifics of each rating, however, but rather the idea that there are some broad standards that are applied in risk management such that there will be considerable overall agreement in terms of assessing highly risky issues.

For the individual investor or wealth manager, it should be encouraging to see that there are tools available that can assist in analyzing the risks in a portfolio (both QPP and RiskGrades analyze total portfolios, as well as individual stocks or funds). At a time when many investors have ended up with portfolios that are far riskier than they had imagined, it is especially useful to become acquainted with tools and techniques for risk management that are available for individual investors and risk managers. The consistency between different providers (like RiskMetrics and Quantext) means that you don’t need to buy into the specifics of one firm’s approach in getting a handle on average risk characteristics.

Disclosure: long PNW