What We Know and Don’t Know About Risk - What We Know and Don’t Know About Risk ... Black Swans

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  • John Longo and The MDE Group 2014

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    WEALTH LEADERSHIP SINCE 1987

    John M. Longo, Ph.D., CFA Rutgers Business School

    The MDE Group

    What We Know and Dont Know About Risk

    The Danish Forum for Performance Measurement Copenhagen, Denmark, June 12, 2014

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    WEALTH LEADERSHIP SINCE 1987

    Outline

    1) Motivation for Presentation

    2) What We Know About Risk

    3) What We Dont Know About Risk

    4) Methods for Navigating Risk in an

    Uncertain World

    2

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    Motivation

    Well known financial textbook, Brealey & Myers

    What we know about Finance:

    Net Present Value

    The Capital Asset Pricing Model

    Efficient Capital Markets

    Value Additivity and Law of Conservation of Value

    Capital Structure Theory

    Option Theory

    Agency Theory

    3

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    WEALTH LEADERSHIP SINCE 1987

    Motivation (2)

    What we dont know about Finance:

    What determines project risk and present value?

    Risk and return what have we missed?

    How important are the exceptions to Efficient Market

    Theory?

    Is management an off balance sheet liability?

    How can we explain the success of new securities and

    new markets?

    What risks should a firm take?

    What is the value of liquidity?

    How can we explain merger waves?

    Why are financial systems so prone to crisis?

    4

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    WEALTH LEADERSHIP SINCE 1987

    Mark Twain Quote

    5

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    We Know: Long-Term Risk-Return Relationship: Unfortunately it May Take 20 Years to Work !

    6

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    Detail on Long-Term: Decades with Zero Return

    7

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    WEALTH LEADERSHIP SINCE 1987

    We Know: Performance Rankings Are Erratic

    Source: JP Morgan Guide to Markets

    8

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    WEALTH LEADERSHIP SINCE 1987

    We Know: Diversification Reduces Risk

    9

    My ventures are not in one bottom

    trusted, Nor to one place; nor is my

    whole estate upon the fortune of this

    present year: Therefore my

    merchandise makes me not sad.

    Antonio, in William Shakespeare's

    "The Merchant of Venice", Act 1,

    Scene 1.

    Shakespeare on Risk Management (1597)

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    WEALTH LEADERSHIP SINCE 1987

    We Know: Diversification Is A (Modest) Free Lunch

    Source: JP Morgan Guide to the Markets, 2Q 2014.

    10

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    WEALTH LEADERSHIP SINCE 1987

    68% 66%

    88%

    Cash Outperforms

    32%

    Cash Outperforms

    34%

    Cash Outperforms

    12%

    0%

    10%

    20%

    30%

    40%

    50%

    60%

    70%

    80%

    90%

    100%

    Cash vs. Stocks Cash vs. Bonds Cash vs. Both Stocks and Bonds

    Bonds Outperform

    Stocks Outperform

    Either Stocks or Bonds

    Outperform

    FREQUENCY (RATE) OF OUTPERFORMANCE FOR CASH Vs. STOCKS & INCOME

    OVER 1-YEAR PERIODS (1926-2011)

    We Know: Cash is Rarely King

    Source: Fidelity Investments

    11

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    WEALTH LEADERSHIP SINCE 1987

    We Know: Interest Rates are Tied to Inflation

    Source: J.P. Morgan Guide to Markets, 2Q 2014

    12

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    WEALTH LEADERSHIP SINCE 1987

    We Know: Interest Rates Impact Risk Through the Time Value of Money

    13

    Buffett:

    Portfolio Theory was

    invented by Aesop in 600

    B.C. when he said, A

    bird in the hand is worth

    two in the bush.

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    WEALTH LEADERSHIP SINCE 1987

    We Know: The Taylor Rule and the Fed Funds Rate

    Interest rates cant fall below

    zero, so the Fed or ECB must

    use atypical monetary policy

    in combinations with large

    government stimulus.

    Source: Paul Krussgman, Zero lower bound

    blogging, New York Times, January 17, 2009.

    14

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    Although we cannot agree on the precise definition of risk, there is a more general consensus on the factors or levers that drive risk:

    Market Exposure (e.g. Beta, Duration, etc.)

    Leverage

    Concentration

    Liquidity

    Quality

    Transparency

    Lesson: Watch the risk levers ex-ante

    We Know: Most of the Drivers of Risk: Unfortunately, We Cant Forecast Risk Well

    15

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    WEALTH LEADERSHIP SINCE 1987

    We Know: Reversion to the Mean Over the Long Term

    VIX Example: Eventually reverts back to around 18-20 after shocks dissipate.

    Many other examples (e.g. P/E, credit spreads, etc.)

    16

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    WEALTH LEADERSHIP SINCE 1987

    Bubbles dont repeat exactly, but the boom / bust cycle continues. Fear and greed are inextricable parts of human nature.

    Tulip Bubble

    South Sea Bubble

    Nifty Fifty of the 1970s

    Merger Mania of the 1980s

    Internet Bubble

    Credit and Real Estate Bubble

    Social Media Bubble (e.g. WhatsApp, Snapchat)

    Cloud Computing Bubble

    We Know: Bubbles Repeat Due to Human Nature

    17

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    WEALTH LEADERSHIP SINCE 1987

    We Know: Prices May Be Nonlinear (Bubbles Possible)

    18

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    WEALTH LEADERSHIP SINCE 1987

    We Know: Prices May Be Nonlinear (WhatsApp)

    19

    Price tag:

    $19

    Billion!

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    We Know: Prices May Be Nonlinear (Snapchat)

    20

    Snapchat

    rejects $3

    billion cash

    offer from

    Facebook

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    WEALTH LEADERSHIP SINCE 1987

    We Know: Security Prices Not Normally Distributed Dow Jones Example (Actual Distributions)

    Source: PIMCO

    21

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    WEALTH LEADERSHIP SINCE 1987

    We Know: Black Swans Exist

    22

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    WEALTH LEADERSHIP SINCE 1987

    Black Swans cannot be predicted consistently, but their impact may be limited if we control the risk levers carefully and buy (cheap) insurance.

    Examples of cheap insurance:

    Deep out of the money options or other derivatives, before volatility spikes.

    Your portfolio will still take a hit after the black swan arrives, but losses may be more manageable.

    Dealing With Black Swans

    23

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    WEALTH LEADERSHIP SINCE 1987

    We have known for many years that volatility tends to follow volatility (e.g. ARCH / GARCH models).

    Q: Why? A: Investor psychology, delayed reaction to news, momentum trading, margin calls, and other reasons.

    Hence, some volatility can be predicted (e.g. the second leg).

    Risk Outside of Black Swans

    24

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    Predicting the 2nd Leg of Risk

    25

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    Cut your losses short and let your winners run.

    Gain more on your winners and lose less on your losers (i.e. impact ratio).

    Never fight the tape.

    Bet bigger if more trades are going in your favor; otherwise, bet lesser amounts of capital.

    Try to be greedy when others are fearful, be fearful when others are greedy. (Attributed to Warren Buffett)

    We Know: Conventional Wall Street Wisdom On Risk

    26

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    There is no uniformly agreed upon definition of risk.

    Most people view risk as the chance of losing money or

    not achieving an important goal.

    Others may view risk as volatility, or performance relative

    to a benchmark.

    Modern finance theory suggests that risk is to be voided,

    unless you are compensated with extra return.

    We also cant effectively forecast the first leg of risk (e.g. Black Swan events).

    We Dont Know: How to Precisely Define Risk (Even Though We Know Most O