Risks, Not Risk, Again: No Generic concept Exists

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One of the most important things I am here to teach readers is that there is no such generic concept as risk.  There are risks, and they must be handled separately.  Generic measures of risk such as standard deviation of returns, beta, etc. are unstable.  This was driven home to me when I heard a presentation from endowment investment advisors, where they talked about their models, and how the models translated current economic statistics into investment decisions.

I’m sorry, but the models can not be that good.  The financial markets are only weakly related to the real economy in the short-run, though the tie gets strong in the long-run.

Economies are unstable; get used to it.  The concept of equilibrium is also not useful, and it holds economics in thrall, because it makes the math work, even though equilibrium never occurs.

It is far better to look at your investment in an oil refiner and ask “What are the possibilities for where crack spreads will be a year from now,” than to look at the beta, correlations to anything, standard deviations, etc.  The coefficients aren’t stable.

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Many advisors would rather follow a false certainty, than have to think for themselves, and have to deal with the complexity of the markets.

I am a quantitative analyst, and a very good one.  That is why I pay attention to the limitations of models, and the possibility that past data might be special, and not so relevant to the present.  It is far better that you pick over your portfolios, and ask what risks they are subject to, than to look at standardized risk measurements that describe the past or present.

Be forward looking.  What can go wrong?  Analyze each company.  Find the three most pertinent risks — read the 10-K if you are having a hard time.  See if you think the risks are worth taking.

But be assured of this.  Merely by looking at market price derived variables for stocks, you won’t learn anything valuable about the risks of what you own, or might own.  You need to think like a businessman, a sole owner, and ask whether the risks can be ably faced.

To the Consultants

Your models are garbage.  You need to review your managers at the holdings level, or you are doing no good at all.  All of the aggregate statistics hide the instability.  Far better to understand the qualitative methods of managers, and analyze whether they have a durable competitive advantage or not.

That may not seem so scientific, but science is put to bad ends in areas where there is no good science.

If I were hiring managers, I would spend a lot of time on process and people, and ignore a lot of other items.

Summary

Mathematics is of limited use in analyzing investments and investment managers.  It is far better to look for those that have good business sense, and invest with them.

By David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.