Real Risk

The ice we skate is getting pretty thin
The waters' getting warm you might as well swim
My world's on fire, how about yours?
That's the way I like it 'cause I never get bored
--Smash Mouth

Last week's RISE conference reiterated my sense that portfolio managers just do not manage tail risk well. They have been raised on the portfolio theory concept and know how to manage idiosyncratic, security specific risk. But they are largely unprepared for systemic risk that takes all risky assets down in a correlated fashion.

Coincidently, this morning I happened across this article on John Mauldin's fine site. The author distinguishes between trivial risk and real risk. Real risk is the risk that can wipe you out. He argues that many measures of risk in the mainstream finance demand (e.g., beta, standard deviation, VaR) do not capture real risk.

He includes the above chart to demonstrate that severe stock market losses occur much more frequently than predicted by normally distributed models.

I also like his concept of birthday risk. Most people have a 15-20 year window for serious investing. Depending on when you were born, this window fall over a 15-20 year period where risky investments go thru the roof (e.g., 1981-2000), or when risky assets tread water at best (e.g., 1966-1980).

He suggests that the argument that 'stocks always go up in the long run' is an impractical one. It won't matter for investors who by chance are dealing with the wrong investment window and who may not be able to stick around for the 'up' cycle.

He concludes with some ideas on how to manage tail risk, including the potential value of market timing and considering asset allocation in terms of assets that are truly uncorrelated.

Overall, an interesting and recommended read.

position in SPX