The New Tools To Measure Risk In Your Portfolios

January 5, 2016

by Michael Edesess

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Understanding the risks embedded in a portfolio is central to providing value to clients. Traditionally, risks have been measured statistically – with standard deviation or value-at-risk (VaR). The shortcomings of those metrics, however, have been well documented. In response, a new generation of analytical tools has emerged that allow advisors to assess risk through scenario analysis – looking at portfolio outcomes through the lens of a storyteller.

The last two books on the financial industry that I reviewed for Advisor Perspectives emphasized the importance, in attempting to understand economic behavior, of “stories” and “narratives.” In John Kay’s book, “Other People’s Money: The Real Business of Finance,” he writes, “We deal with radical uncertainty through storytelling, by constructing narratives.” Later, he elaborates: “The reality of market behavior … makes little use of probabilistic thinking but relies on conviction narratives – stories that traders tell themselves, and reinforce in conversation with each other. Such narratives are the means by which we cope with radical uncertainty – the unknown unknowns.” Nobelists George Akerlof and Robert Shiller, in their book, “Phishing for Phools: The Economics of Manipulation and Deception,” use the “stories” theme repeatedly. As they write, “people tend to think in terms of stories … ‘mental frames’.”

I will examine how one software product, HiddenLevers, has implement a scenario-driven methodology to portfolio analysis. But, first, let’s look at the advantages of scenario analysis over traditional risk measurement.

A story about narratives

A little over a year ago, I attended a conference in Hong Kong of INET, the Institute for New Economic Thinking, hosted by the Fung Global Institute (now the Asia Global Institute). INET is a reformist economic policy think-tank, founded by George Soros and others in response to the global financial crisis of 2007 and 2008.

On the day that I attended, John Kay was also at the conference. After an address by a luncheon speaker, Kay spoke up from the audience. He said, as he does in his book, that “risk” was something that takes the form of “narratives.”

After lunch I attended a session in which the lead presenter, I’ll call him Professor X, began by referring to Kay’s comment. Then he shrugged and made a gesture of waving his hands in the air. His clear point was, “What can you do with that?”

Professor X and a passel of his graduate students then launched into a presentation, as replete with mathematical formulas as any I’ve seen, on the subject – as I recall – of risk premiums in foreign exchange trading. I attempted to engage with them on the question of how there can objectively be risk premiums for foreign exchange trading when it is a zero-sum game; but my simple question was so buried in their talk under layers of mathematics – like the pea under the princess’s bed – that it was hard to discuss with them.

Professor X’s shrug and wave of the hands seemed to mean, “You can’t do mathematics with narratives.” To which I would say, so what? Mathematics is a tool; you use it when it is a good fit to your problem and can help solve it. But it’s not obligatory.

The scenario approach to envisioning the future

Nevertheless, mathematics – or at least arithmetic – does arise naturally in many contexts. The scenario approach to investment planning is a combination of narratives with mathematics when it is needed. If done right, the math doesn’t drive the approach; the tail shouldn’t wag the dog.

I’ll admit to some residual bias in favor of the scenario approach. I was an author of an article that appeared in The Journal of Portfolio Management back in 1980. At the time, I was actually employed doing research on renewable energy. It was during the first (and temporary) phase of widespread enthusiasm for the field, after nearly tenfold increases in the price of oil in the 1970s. I tell the story in my book The Big Investment Lie. It was my first attempt to get out of the deeply unsatisfying field of institutional investment consulting. Renewable energy seemed like a productive field to get into.

But before the switch, I had been a partner in a four-man consulting partnership. We were trying to tout the idea, with our mostly investment-manager clientele, of using scenarios to plan investment strategy. I personally thought it could be a way to make what we were doing less brain-dead. We held a conference on scenarios for our clients and invited – and paid – several fascinating speakers. Unfortunately, although our business was otherwise reasonably successful financially, the conference wasn’t. Furthermore, we hadn’t fully worked out exactly how we would use scenarios.

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The New Tools To Measure Risk In Your Portfolios