BULLS & BEARS: How some measures of risk breed investor complacency

Risk. Webster’s defines it as “the chance of loss; also the degree of probability of such loss.” Specific to the act of investing, one might add: any investment activity that may lead to a permanent loss of capital.

Investors can’t eliminate risk. However, by following Webster’s definition and attempting to determine the “degree of probability” of a potential loss, the investor can then decide the wisdom of proceeding with an investment.

In cases where he judges the probability of loss is high, the investor should simply move on to evaluate another investment opportunity.

Wall Street has devised more complicated measurements of risk. Many financial firms use mathematical formulas that massage historical data and arrive at figures that convey a degree of precision in risk measurement.

The VIX, or volatility index, is a commonly cited measure of risk. The premise behind this measurement is that the greater in magnitude a security or the market fluctuates, up or down, the riskier it becomes. These days, this measure of risk is near a 20-year low.

Another quantitative measure of risk is called VAR, or value at risk. Many hedge funds use risk-based software programs that seek to answer the question: How much could their portfolio lose if a certain event were to occur? A VAR statistic has three components: a time period, a confidence level and a loss amount.

Academics talk about the “equity risk premium,” or the excess return that an individual stock, or the overall stock market, provides over a risk-free rate of return. This excess return compensates investors for taking on the relatively higher risk of stocks. Equity risk premiums are said to be at low levels today.

Frankly, the desire to boil down risk to a precise measurement strikes us as an act of hubris and an overestimation of one’s abilities.

Back in the 1990s, the hedge fund Long Term Capital Management used sophisticated mathematical models to control the downside risk in its portfolio. The firm’s investment returns were impressive until external events caused its portfolio to behave differently than the risk models had predicted, leading to a multibillion-dollar collapse. And that in a nutshell is the lingering problem with many of the mathematical models used today on Wall Street-they work fine, until they don’t.

Instead, we believe investment risk is similar in concept to what the late Supreme Court Justice Potter Stewart once said about hard-core pornography-it may be hard to define, “but I know it when I see it.” And in that regard, the average investor, armed with the proper temperament and some basic skills to value securities, can recognize and at least minimize exposure to investments that might cause a permanent loss of capital.

Why this laborious discussion about risk? Well, because there are plenty of indications that the global investment community appears quite complacent in its attitude toward investment risk at present.

It would be a mistake to assume that all investors have perfectly hedged their risks and are thus immune to any forces that might upset the apple cart. We will continue our discussion on this important topic in two weeks.