Most people are risk-averse -- particularly with their own money. But if your business is to assess risk, whether as an actuarial or a hedge fund manager, you must find a way to quantify the risks that your company takes. The problem is that that's like guessing how much money to set aside in a health care flexible spending account for the year ahead when you don't know whether anyone in your family will fall ill.
Stay on Top of the Bear-Market Rally with the kind of technical analysis that looks ahead and assesses the probabilities of how long it will last. Elliott Wave's Financial Forecast Service brings you lively discussions of market psychology, detailed price charts and sophisticated financial forecasting. Read more about the
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Wall Street hires sophisticated number-crunchers to figure out all kinds of risk for investments, but their computer models give only the illusion of evaluating risk. As recent events have shown, the risk analysts at investment banks and rating agencies guessed wrong about the safety of securitized mortgages. Let's take a moment to remind ourselves that risk is a chance of loss or injury -- in other words, there are no certainties, only probabilities. With that in mind, here's how Bob Prechter explains why not even Wall Street can model away risk.
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Excerpted from The Elliott Wave Theorist by Bob Prechter, published March 20, 2009
You Can’t Model Away Risk
My friend Tom Rehberger (www.investpag.com) spent two decades designing trading systems for hedge funds. In the process he learned a lot about the essential flaws behind the models they sought to build and struck out on his own to build a better model. Based on experience, he made some insightful comments about the nature of financial risk:
Stops and limits are two of the best ways to curve-fit a model to get results that will never be duplicated in real time. I have worked with and created many models with stops and limits that have great looking results which can’t be duplicated with real money. Models built this way don’t work.
Another big disaster is the unknowing exchange of risk. Most modelers, often without knowing it, exchange market risk for hedge or spread risk. They think they have eliminated market risk, so they feel comfortable using extensive leverage to expand returns. But hedges and spreads are not fixed; they are dynamic. As we have seen lately, banks and brokers did not realize they were taking huge spread risk. Certain strategies can seem to lower short term risk, but they typically ignore “event” risk. Traders and modelers forget that all metrics are dynamic even if for periods of time they appear stable. When they “curve fit” to metrics, it degrades returns even more. Metrics change; a model must allow them to do so.
Tom’s point is that you can see market risk. It is right in front of your face. That way you can deal with it directly. Quants who try to model away market risk for hedge funds simply exchange it for risks that they do not recognize. Risk can hide, but it never goes away. Consider investors who (1) thought their hedge fund managers had found a foolproof way to make 20 percent per year in an ever-stable environment for sub-prime mortgages, (2) thought they were beneficiaries of a consistent, riskless return of 12-15 percent annually from an account managed by Bernie Madoff or (3) bought stocks in the past 15 years because they read a book saying they would inevitably compound capital gains at the rate of nine percent a year over the long term. These investors all ran up against the problem Tom describes: risk that they did not recognize. The only option for an investor who wants to succeed is to understand market risk and learn to handle it.
The publications of Elliott Wave International are not for everyone, because many people want to figure out how to avoid risk while making money in markets. It can’t be done. We assess markets head-on, providing a basis for conscious, aware decision-making. As Tom says, this is the only way to have a handle on what your risk is. And at times when the risk seems too high or uncertain, we recommend sitting in Treasury bills, biding your time until the next opportunity. It is an intelligent way to invest.
Stay on Top of the Bear-Market Rally with the kind of technical analysis that looks ahead and assesses the probabilities of how long it will last. Elliott Wave's Financial Forecast Service brings you lively discussions of market psychology, detailed price charts and sophisticated financial forecasting. Read more about the Financial Forecast Service here.