4 things risk is NOT

Rick Bookstaber, head of risk at Fabric, a startup he founded to provide risk-management software to investors, talks to Morningstar's Christine Benz and Jeff Ptak.
By Morningstar |  22-08-21 | 

1, Risk is NOT a number.

There are risk managers in a lot of different areas.

When it comes to financial markets, the risk manager is really looking at market risk; trying to make sure everybody's aware of the potential of a portfolio to lose money if certain events might occur. It's simply a matter of looking at positions, measuring how they interrelate, so that you know if one event or another occurs, there's no surprise. There's always surprises that can happen in the market, but at least for something that you can look out and see as a potential event, you're not surprised to discover when that event occurs, that you've lost 15%. Because you know your risk is such that that wouldn't happen.

Risk isn't a number, whether it's value at risk (VaR), or however else you want to look at it. Risk really is a narrative because when something happens in the market it's not just one jolt and that's the end of it. When I look at risk, I look at it as a story. If I'm concerned about the risk, say from inflation, or from the potential of a bubble in technology, I'm not just saying, oh, the risk is 12. I don't know what 12 means in the concept of risk. What I'd be seeing is, here's the way that that type of event may play out. And depending on how it plays out, here's the path that risk might take.

So, first order, you can use a number like VaR, which is pretty standard, and say there's a 5% chance that you might lose more than say 25% on your portfolio. But that ignores the fact that the markets are dynamic, and that you can really present a type of a narrative for what might occur. I use methods that come out as numbers, but behind the numbers to understand risk, you have to know the way you think risk might propagate--what are the things that might occur in the market and how, when those occur, they will unleash second- and third-order effects.

2. Risk Tolerance is NOT the same as Risk Capacity.

Risk tolerance is the amount of risk that you are willing to take. It's a psychological-based sense of risk. Risk capacity is the risk that you're capable of taking.

If you're a trader at a hedge fund, or if you're a pension-fund portfolio manager, your risk capacity is the amount of exposure that you're allowed to have--that's the amount of capital that you have at your disposal to invest. Your risk tolerance is how much you're willing to invest, given the nature of the market environments today. So, you can have very strong risk tolerance. But the fact is, you can only invest the amount that you have available to invest. So capacity is your constraint, in that case. You might have a lot of capital, but if you're very concerned about the market, then your tolerance is the constraint. And you're going to have capital available that you're just not putting at risk.

3. To decompose and analyze risk, do NOT look at risk asset by asset.

People have started to realize that it's pretty hard to generate any sort of an alpha in the markets; it's hard to beat the market on a return basis. So, if you're going to try to manage your portfolio, the place you can have the greatest impact is in the risk dimension, rather than the return dimension.

The way to get people to understand the importance of risk is simply that--for them to know the limits of what's possible in trying to reach for yield and trying to beat the market. And the more they pull back from feeling that that's something that's possible, they now have to say, “How can I then improve my position by getting rid of risks that are unnecessary or that can be either diversified or hedged away?”

The best way to do it is to look at risk not on an asset-by-asset basis, and also not look at risk overall in the portfolio on an aggregate basis, but use what are called risk factors. Risk factors are really the building block of risk. So, it might be things like exposure to sectors; exposure to different styles; are you a high-cap versus low-cap? Are you in value versus growth? Exposure to countries? And then you can say, “Do I have exposure in various risk areas?” For example, “Am I unusually exposed to China?” Well, it may be that all of your stocks are U.S. stocks, but yet they may have a lot of exposure to China, which you didn't realize because they have a strong supply chain relationship with China.

To get a handle on risk, do not look at risk asset by asset. It's not pulling everything together and looking at the aggregated risk of your portfolio, where you have to assume, how are things related? How are they correlated? It's looking at risk, risk factor by risk factor and deciding, do I really want to have that much exposure to technology? Do I really want to have that much exposure, as I just mentioned, to China? Does it turn out that I am very highly biased in growth versus value?

4. Past risk is NOT indicative of future risk.

Almost every risk method that you see out there looks at what returns have done, how have they bounced up and down over the last one or two years. And if that's what risk has been like over last year or two, that's my best guess of what it'll look like in the future.

Past performance is not indicative of future returns. Past risk is not indicative of future risk. History has value. But if you don't look at the market as it stands today, you're ignoring the essential information that you need to have to get a good assessment of risk. For example, if there's more leverage in the market now than there was over the last few years; if people are more concentrated in particular areas of the market now than they were in the past; if credit conditions are tightening--those things all are going to point to risk going forward, being higher than it has been in the past. So, I think you can use history, but you have to condition it on what's the market like right now versus what it's been like historically.

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