Wednesday 24th of August 2011

We all learned from the finance company debacles that valuing a portfolio with a capital item that remained at the same value, lulled many financial planners into a false sense of security. That is, using finance company debentures in investment portfolios reduced volatility and so they assumed this was reducing the risk in the portfolio. The capital value of a debenture in a finance company never reflected that company’s strength or otherwise. Unfortunately for their clients, a permanent loss of capital was a massive risk. So, why do research houses still use volatility as the only measure of risk? Correct me if I am wrong but quantitative research and hence technical analysis is the sole basis of most ratings. And, what does that measure – the past. Sure, volatility is one measure but it is not the only answer to understanding risk in a portfolio. I believe the clients’ of financial planners have a very clear understanding of risk, “Will I lose my money?” What does not seem to be in the forefront of minds with those who construct portfolios, is whether the selected investments can battle through a huge storm without total loss? The true test of risk – the survival of a Black Swan Event (of which we seem to have quite a few in recent years). The Black Swan Theory was developed by Nassim Taleb and he argues the silliness of trying to predict the unpredictable. Nissim Taleb said: “We Don’t Quite Know What We are Talking About When We Talk About Volatility”. If you believe the investments you have chosen will survive severe storms (irrespective of the volatility they may suffer during the storm) then you have de-risked your client’s portfolio. If on the other hand something is dropped into the portfolio because the capital value is stable, maybe it is actually stagnant (i.e. difficult to value or not regularly valued), then risk persists. For this very reason, some of the hardest hit during 2008 were the ‘so-called’ conservative portfolios. You would be better off in most circumstances ignoring volatility – it is probably one of the contributors to many losses incurred since the jolly measure was introduced as a proxy for risk. Sorry Mr Markowitz. Can anyone enlighten me on why so many slavishly follow and utilise research house material which is a regurgitation of the past with one of the main measures applied being volatility? Anecdotal evidence would suggest we would be better off without them. Maybe it is just simple ol’ human nature: “Got to have someone to blame when the going gets tough?”