Blame the Models? Take a Good Look in the Mirror

Is financial modeling to blame for the recent crisis? As always the fault does not lie with the tool but rather with the user. When was the last time you took a look at the validity of Net Present Value or Option Pricing?

The recent, or ongoing, financial crisis has been attributed, amongst other things, to over reliance on quantitative financial models which replaced good business judgment instead of supporting it.

The reason behind the failure of models wasn't simply poor modeling, for the most part. The main reason was poor business and risk management processes which placed blind faith in the models.

In this post I begin to explore the reasons why financial modeling increased the severity of the recent crisis and more importantly, what are the lessons we can implement to our personal finances?

The need for Financial Modeling

With the development of computing power advanced mathematical models enabled the creation of complex new financial instruments and professions such as financial engineering. Mathematicians and statisticians found their way to investment banks and hedge funds due to the increased demand and profitability of these endeavors.

These financial instruments included, for the most part, new underlying assets, that require complex financial models to model their pricing and behavior. Financial models which sadly broke during the recent crisis.

That is not to say that financial engineering and the use of models have been proven unsuitable for the financial markets. Much on the contrary, financial engineering and complex financial instruments help, in many cases, to increase the level of perfection in the market and ease the transfer of undesirable risks from one party to the other.

Models as a Representation of Reality

A Model, by its definition, is a representation of reality. Economics, for example, as any 1^st year student knows is based on very simple models of production, supply, demand and price. The strength and importance of these models is their ability to explain economic behavior even under very simplistic assumptions.

Think of the prisoner's dilemma in game theory or Nash's equilibrium which are very simple models that won their authors Noble Prizes. The beauty of the model is its ability to represent reality with a very limited framework.

As modeling advances assumptions are slowly removed creating more and more complex models which require a better understanding of the mathematic complexity. The reason is simple, the more "free" parameters the model needs to explain the higher the complexity.

Naturally, when dealing with financial instruments and their fair value pricing, models need to explain as much of the price as possible to adequately represent the fair value of the instrument. As such, models have grown quite complex as room for assumptions is very small.

What went wrong?

Before we get too judgmental let's consider the simple, commonly used model of Net Present Value. Net present value is a model used to determine how much a certain stream of cash flows is worth today – or, the present value of the cash flow.

Net Present Value is commonly used to determine the economic sense behind undertaking certain projects and investments. All those in the finance profession, as well as personal finance enthusiasts have probably tried to determine the net present value of a certain undertaking. The problem starts when you dig deeper into the model.

Most people are not aware Net Present Value assumes the following due to the very central role of the cost of capital in the model (further reading on NPV is available here):

• The existence of an efficient financial market – In order to price correctly an efficient financial market is required. NPV cannot be turned into value in the present if an IPO cannot be performed or valuated correctly.
  
  
• Access to financial markets– Without access to an efficient financial market the entrepreneur, again, cannot transform NPV to value in the present.
  
  
• The existence of diversified investors – Adequate pricing of the cost of capital can only be performed by ignoring the specific risk of the investment. A diversified investor, in finance, sees only the market risk when investing (the reason being a diversified portfolio will stay diversified even after investing in this particular project, for example).

When was the last time the Net Present Value calculation you had performed met these requirements? My guess is never.

The model is a helpful tool but the underlying assumptions and limitation cannot be ignored.

The reason behind why many of the financial models broke has to do with the assumption of liquidity and volume in the markets. Pricing models are built to price instruments under a normal market environment, as part of the normal course of business. When stressed scenarios occur the assumptions behind the models cease to exist and the model breaks.

• Black and Scholes model very commonly used for option pricing assumes normal distribution of returns (Not true, obviously).
  
  
• The CAPM Model (Capital asset pricing) which is a corner stone in asset allocation is based, again, on normal distribution of returns but also assumes, amongst others, the following highly debatable assumptions: Perfect availability of information, No taxes or transaction costs and a market portfolio which includes all types of assets (!).

With no liquidity in the markets strange phenomenon start to take place, phenomenon which cannot be analyzed through modeling but rather through good judgment and independent thinking.

The Importance of an Adequate Process

The role of an adequate risk management process cannot be overstated. Financial modeling is a tool, nothing more (and nothing less).

Like any tool the one who uses it needs to understand its capabilities and its limitations. Model limitations are inherent as they are, and only can be, a representation of reality.

Financial modeling will not go away. The need is too strong. What does need to happen is the implementation of robust risk management processes which will continue to remind what are the assumptions and limitation of the models and what the proposed mitigations against these limitations are.

The wisdom of the ancient Greek philosopher Socrates is a fitting quote: "I know that I know nothing" he said, not because he knew nothing because he didn't claim perfect knowledge. A humble state of mind is a very good start.

Related Posts:

• Is Present Value - Value in the Present? The Economic sense behind Net Present Value
• Diversification is Dead. Long live Diversification
• What is the Recommended Investment Strategy for Household Investors?
• Capitalism with Social Equality: A Powerful Though Experiment Demonstrates Our Moral Obligations
• Psychology tricks and increased spending – The Case of Expensive Wines
• The Big Mac Index – Applying Simple Economic Common Sense
• Would You Be Willing To Pay 60% Tax For a Higher Level of Social Equality?

What is the Recommended Investment Strategy for Household Investors?

I've promised to update you, my readers, on my investment decisions. I've decided.

After months of deliberation I've finally decided on getting my feet wet again and bought some stocks on Monday. As readers of The Personal Financier know I am a big fan of investment vehicles that track certain indices such as index funds or ETF's so I've decided on gradually increasing my exposure to the markets via these financial instruments.

Needless to say I have a gift for timing the market, the other way around. Since my recent purchase leading indicators, such as the S&P500 had shed over 5%. That was rather expected as the markets rallied these past couple of months.

In this post I'll share my personal considerations behind my recent decision to increase exposure to stocks. If I breakdown my decision into three main lines of consideration they would be:

• My considerations regarding my desired investment style.
  
  
• My considerations regarding the market environment.
  
  
• My decision to use index funds and ETF's and invest gradually using dollar cost averaging (Investing a certain sum each period).
  

My considerations regarding my desired investment style

So why did I decide to reinvest in stocks again? The reasons behind my newly discovered enthusiasm about the markets and why I decided on gradually increasing my exposure to stocks has a lot to do with what I consider a desired or suitable investment style for me and many other household investors (in my opinion, of course).

During the past couple of years I've been fortunate enough (ironically) to not have to worry about my savings and investments as I had none. I'd bought an apartment and literally invested my funds there releasing me of my need to consider alternative investments. Luckily enough the apartment I had bought has yet to suffer the impact of the housing crisis.

Now, two years later I've managed to save up a sum which necessitates more serious consideration regarding where to invest it and how to both preserve it and grow it, if possible.
Naturally, the state of the markets was enough cause of concern for me to seriously consider my investment plans. Losing my hard earned money is not an option.

The more I thought of it I understood I was failing to obey my view on investments, a view that I had learned after paying "tuition" in investment losses in my early investment years.

#1 I decided sitting on the fence won't get me far
I find out I was literally sitting on the fence. Avoiding decision allowed me to remain unscathed during the recent plummet but I did not earn anything either. I've written a post titled "Who Dares Wins" but failed to follow it.

There is no need to take huge risks for huge profits, just thought out risk for a better chance of meeting my personal financial goals.
Sitting on the fence is not a solution to anything. It's a very easy way out. Usually when I avoid deciding I know something is wrong. So I decided to slowly climb down from the fence.

It does feel much better to have decided and to have the feeling of taking a path and having a purpose. My savings were idling in a short term deposit which barely covers the bank's fees with the low interest rate environment. I had to do something and feel like I'm doing something.

#2 I was guilty of timing the market
I just can't help it. I don't think many can. I always try and time the market. Since one does not usually keep objective score of one's efforts of timing the market we never know whether we are any good at it. I most certainly am not.

No one thought the market would rally 50% after Citi's March earning release. Missing out on such a rally is very costly in terms of investment. And now, having raced 50% up the more probable scenario is a downward technical correction in prices… and then? Timing the market almost never works so I've decide to stop and just invest a portion at a time thus averaging these corrections out and enjoying the long trend in prices which will hopefully be a bullish one.

#3 I finally remembered I am a long term investor
It took some time but I've finally remembered I'm actually a long term investor. I think it's hard on humans to invest for the long term. We are programmed to be impatient and impatience is a bane for investors.

I think the birth of my baby boy had something to do with it. I've decided on treating my investments as his. An 18 year investment term should be enough to be considered long term (some may argue).

My considerations regarding the market environment

In my recent posts I've written about a correction in prices which is probable to follow the recent rally. I had thought the stress tests will give enough reason for sophisticated investors to realize profits and change the trend. This hasn't happed, yet. Markets have shed 5% but this can be considered only profit taking on an uptrend.

I still believe a correction is in order but since I've decided on quitting my market timing efforts I've decided to ignore this belief. This is actually a great relief. No one seems to really know what's going on anyway.

It certainly wasn't short-term considerations regarding the economy which got me to reinvest. There seem to be fundamental reasons to believe the global economy will get better in the near future (2-3 years).

#1 Very low interest rate environment leaves little choice
There is money out there looking for reasonable returns. With interest rates this low this money has little choice of investment and will turn, eventually, to the stock market. Interest rates on deposits are so ridicules many investors will find it very hard to accept.

This low interest rate environment will hopefully serve to set the markets back in motion with cheaper credit more motivation to capitalize on this opportunity.

There are risks to such a low interest rate environment, together with increasing influx of money into the markets. Inflation will follow and will have to be controlled but hopefully we'll be on a correct course by then.

#2 Risk appetite seems to be returning to the markets
One of the effects of the recent crisis has been a dramatic impact on risk appetite. When risks seem to be that high no return is justifiable. Risk appetite is perhaps the most important thing for the stock market which is, in essence, a risk-return tradeoff.

Recently there seems to have been a shift in trend and the risk appetite is reappearing. The public's share in the stock markets is increasing through institutional investors and, hopefully, it won't be long before the mass market will find stocks appealing again.

#3 Cyclicality
As my market timing days are over I am better equipped to use one of the characteristics of financial markets in my advantage. Cyclicality is a common trait of financial markets. Though it never seems so in times of prosperity or times of depressions, the tide will turn and the markets will change.

Keeping a presence in the market is vital for long term success and profiting of cyclicality.

My decision to use index funds and dollar cost averaging

My considerations should be clear by now in light of my investment style and market beliefs.

#1 Beating the market is as hard as timing it
Chances are you or the institutional investor you've chosen though a fund or IRA cannot beat the market. For this reason buying the market is the way to go. Fees and commissions paid are often unjustified and hurt portfolio performance with no real abnormal returns over the market.

Index funds are cheap in fees, are simple to follow I believe serve best the needs of household investors.

#2 Dollar cost averaging is a good way to gradually increase exposure
Uncertainty rules the markets, especially today. I would be very nervous had I invested my entire savings in one period. The market is still very fickle and dangerous. Naturally the risk – return equations dictates that averaging investments over time will yield lower returns, and it does, but it is important for sleeping at night.

Dollar cost averaging enables me to remain content even when markets correct themselves downwards. I'll just buy more, cheaply. When markets are bullish again I'll profit on the average investment.

I believe the outlines I've described to be the optimal solution for independent household investors under the current market conditions. I am not recommending anything to anyone. I'm simply describing my strategy as I've promised to do in the past.

I would not like to expose the size of my investments but rather the portion. I've invested 10% of my portfolio in stocks (US Index) and will continue to do so on a monthly basis.

I will update my readers on how my portfolio progresses. By next week I will hopefully have finalized my planned asset allocation and will share it as well.

Related Posts:

• Stock Surges Are Usually Unexpected – How To Make Sure You Won't Miss Out
• Know your Portfolio - Three Simple Charts Can Make a World of Difference
• Stock recommendations from analysts or brokerage houses: How valuable are they?
• Diversifying your risk in the stock market
• Key psychological factors in stock market success
• Tips for young investors
• Comparing Bonds Vs. Stock as an investment
  

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The Japanese Banking Crisis of the 1990's: Are We Facing a Similar Stagnation?

What can we learn from the 1990's Japanese banking crisis and the long slump in the Japanese stock market? Are we facing a similar scenario?

Price levels in stock markets worldwide are increasingly becoming attractive with each day brining yet another slump. The time of the long term investors has come. Still, a relentless doubt lingers on – Does this crisis represent an unorthodox change in the economy? Have the markets set into a recession which might take more than the usual 1-3 years to recover from?

The readers of The Personal Financier are familiar with my favorite example I often use when demonstrating why long term investing in stock is not risk free, as the odds suggest. That example is of the Japanese market which hasn't really recovered from the banking crisis it had experienced in the end of the 80's and early 90's.

The Japanese stock market, represented by the NIKKEI225 index has slumped from a level of almost 40,000 points in 1990 to 7,000 in 2003, a level which the Japanese market is currently revisiting in this crisis. The market hasn't shown any real recovery and has touched the 18,000 points level briefly in 2007.

The Japanese stock market is the stuff of nightmares for all long term investors and demonstrates the significance of geographical diversification.

The big question is: are we witnessing the Japanese banking crisis all over again in the US and western economies? Will the market slump for decades before showing signs of recovery?

The intuitive answer would be: no. No crisis is like another. Still, as I'm constantly considering buying into these levels of stock prices I thought a comparison of the two will prove interesting.

The Japanese Banking Crisis of the 1990's: Sources and Lessons

In January 2000 the IMF (International Monetary Fund) published a paper titled "The Japanese Banking Crisis of the 1990's: Sources and Lessons" which examined the characteristics of the crisis. Hopefully this paper would be able to shed some light onto our current situation.

The paper traces the roots of the crisis to accelerated deregulation and deepening of capital markets without an appropriate adjustment in the regulatory framework as well as to weak corporate governance and regulatory forbearance. Sound very familiar doesn't it?

The favoring economic conditions of the late 1980's Japan which included above-trend economic growth and near-zero inflation resulted in a considerably lower risk premium for the country and a marked upward adjustment to growth expectations which in turn boosted asset prices and fueled rapid credit expansion during the period. Still familiar…

Those who forget history are bound to repeat it. The exponential growth in the derivatives market along with a weak, passive and partial regulatory framework played a major part in the current crisis as well. Weak corporate governance as demonstrated in weak risk management and lack of internal controls proved fatal again.

The foresight of the IMF paper is rather remarkable: "The Japanese banking crisis serves as a warning that such a crisis can befall a seemingly robust and relatively sophisticated financial system".

The question regarding the unusual length of the crisis is answered to some extent
According to the IMF's paper weak corporate governance and regulatory forbearance stifled any incentive for meaningful restructuring of banks as well as their corporate borrowers.

Forbearance and restricting of bad loans – The structure of the banking system in Japan is different an important to understand as it contributed to the length of the crisis. Main banks in Japan act as quasi-insider monitor of the borrowing firm and as a mediator when borrowers fall into stress. This is advantageous as the monitoring costs are lower due to scale advantages of information on borrowers. Unfortunately, these main banks were reluctant to admit they had failed in identifying bad loans and began restructuring them, including the unpaid interest in yet another credit given.

By restricting non-viable loans banks actually increased the amount of problematic credit issued in the market. The end is obvious.

Capital Base - To salvage their deteriorating capital base banks issue more subordinated debt in higher returns to institutional investors thus further increasing the exposure to bad loans throughout the market (always suspect high returns). Furthermore, banks looked to tap unrealized capital gains to increase capital base, thus selling their stock and bond holdings and real-estate.

Weak corporate governance – The ownership structure and the board of directors' composition created little in the way of motivation for sound corporate governance. Owners had been dependent on the credit issued by banks and the boards of directors were comprised of former employees which were expected to hand over the board sit to other employees at the end of every term as a sort of bonus for the years worked at the bank.

Bank management was not under pressure to maximize profitability and returns and the absence of the necessary checks and balances meant no incentive for proper restricting or dealing with problems.

Regulatory weakness and forbearance – It is argued that the strategy of the government, postponing in dealing with the problems, actually raised the fiscal cost of the final resolution of the banks.

The authorities did very little in the way of arresting the decline in the conditions of the banking systems up to 1995. Regulators feared public panic in light of the strong measures needed to salvage the banks which grew in light of the lack of insurance on deposits.

Again, the IMF paper is amazingly insightful: "By giving rise to moral hazard problems, regulatory forbearance and "too big to fail" doctrines can lead to "gamble for resurrection" which often weakens financial institutions further".

Interest rates in Japan have been very low over the past decade and the economy is stagnant. Are we facing the same market conditions?

Conclusions for the current crisis

I felt calmer after reading the IMF paper and writing the aforementioned. It seems both crises have similar characteristics from a quick glance but a deeper examination proves the two are also different.

Regulators world-wide, I'd dare say under the leadership of Bernanke, seem of have learned and implemented the lessons in full. Lehman brothers was a mistake but no one could have foresaw it at the time (it was important to let Lehman fall from the moral hazard perspective on things). Government interventions are enormous and central banks are very attentive to the markets.
Furthermore, corporate governance may have played a part in this crisis but it was lack of adequate risk management and greed that were at the root of the current fall, not forbearance, which is somewhat comforting. Greed can be associated with economic cycles and will give way to prudential management every other cycle.

As far as restructuring and bad loans are concerned banks did delay some write-offs but we are also witnessing the biggest losses in the history of the world which surprisingly serve as a comfort.

The big questions of how much more financial waste is buried deep in balance sheets of financial institutions will remain unanswered but hopefully this crisis will be resolved in less than a decade.

Nationalization of banks, including the biggest two, may be very unpopular but it seems there isn't much choice in the matter and in that case earlier is better as the Japanese example illustrates.

The US market has defiantly had a lost decade as all major stock indices are revisiting levels they hadn't seen for 13 years. Still, perhaps this is an opportunity of a life-time. I, myself, am becoming more and more agitated and I do believe I will buy my way back in the markets in the near future. As I promised before I will update on my decision on this blog as it may be an interesting test case for the long-term.

Related Posts:

• Capitalism with Social Equality: A Powerful Though Experiment Demonstrates Our Moral Obligations
• The Big Mac Index – Applying Simple Economic Common Sense
• Is the Stock Market a Big Ponzi (Madoff) Scheme?
• Would You Be Willing To Pay 60% Tax For a Higher Level of Social Equality?
• How Can they Possibly Afford That? Or Is Money in the Eye of the Beholder?
• How to Protect Your Money From Inflation
• On the Psychological Effects of Ownership and Overpricing

Behavioral Finance in Everyday Life – The Lottery as a Case Study

Is lottery a tax on stupidity or are our flawed psychologies playing another trick on us?

My wife and I usually enjoy strolls around our neighborhood on weekends, especially on sunny winter days. We live in the city and in our last stroll I kept noticing lottery advertisements everywhere as if they were beckoning to me.

Lottery has been deemed a tax on stupidity for a good reason. Every smart and aware consumer knows better than to throw money away on odds smaller than those of getting hit by lightning 3 times in a row.

Still, I couldn't help but buy a ticket. I felt I'd be I'd ignoring all the signals I had received that day calling out to me: buy and ye shall win. After having bought the ticket, for some reason, I'm full of hope and a very strong sensation of confidence in my chances of winning something.

I'm sure many of you have experienced that feeling before as well. Somehow, even though I am aware of the slim odds an unjustifiable feeling of optimism surges and the thoughts of all the things I'm going to do with my soon to be acquired financial independence overwhelm me.

There's a certain bias at work here and as my readers know I love psychological biases. This feeling of elation and of profits to come reminded me something. I usually get the same feeling when I make a stock investment. I simply can't be more certain this particular stock will drive my portfolio to new highs. Where does this conviction come from?

Behavioral finance and hedonic psychology - Daniel Kahneman and Amos Tversky's work

Daniel Kahneman is an Israeli psychologist and Nobel laureate, notable for his work on behavioral finance and hedonic psychology. With Amos Tversky and others, Kahneman established a cognitive basis for common human errors using heuristics and biases, and developed Prospect theory.

Kahneman and Tversky's work on behavioral finance is one of the most interesting and important to anyone who wishes to learn of the limitations of human rationality and the psychological biases that play a key part in our "rational" thinking. Their work is very relevant for investors everywhere as it ties in very tightly to stock market success and failure due to the affects of psychology on us, as investors or traders.

The Representativeness Heuristic – A wrong perception of chance

Would you choose consecutive numbers like 1,2,3,4,5 for the lottery? I'm guessing that you won't. But why not choose these numbers?

1,2,3,4,5 have the same chances of appearing than 2,8,12,23,35 but the last seems much more probable to be the winning numbers due to their randomness. Our minds are programmed in such a way as to correlate order with intention, which is mostly true. Still, there are times when this is obviously false.

The same phenomenon exists in the roulette where the combination red-red-red-black-black-black is thought of as much less likely than black-red-red-black-red-black. We have a certain expectation of nature restoring order to it, offsetting the results.

The Overconfidence effect and Optimism bias

Very common in investors the overconfidence effect is a bias in which people are correct in their judgments far less often than they think they are. For example, for certain types of question, answers that people rate as "99% certain" turn out to be wrong 40% of the time. Overconfidence is one kind of what is called the miscalibration of subjective probabilities.

You really can't get any more optimistically biased than hoping to win the lottery against unbeatable odds.

Apparently the lethal combination of overconfidence and optimism bias is very common and very hard to resist. According to Kahneman and Tversky only seasoned stock market brokers, weatherpersons and dog track analyists have shown some resistance to the effects of these biases.

I'm still hoping to win something but somehow I'm a little less confident in my guesswork. Still, people do win.

If you find judgement under uncertainty and heuristics and biases as interesting as I do please let me know. In the near future I hope to write more on these issues. In the meantime, you may be interested in Kahneman and Tversky's Judgment under Uncertainty: Heuristics and Biases

Related Posts:

• Valuation and Risk Measurement Models under Heavy Criticism – What Went Wrong?
• Coming To Terms with Never Getting Rich – A Look at the Pre-Requirements
• Key psychological factors in stock market success
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Senior Regulators to Senate: Surprised at the failure of Voluntary Regulation. Where They Really That Naïve?

".. for the imagination of man's heart is evil from his youth" (genesis 8:21)

Three senior regulators were apparently very surprised by the behavior of financial institutions and especially investment banks and the part they played in the current crisis. Where they really that naïve? I find it a bit hard to believe.

What the regulators had to say

Chris Cox, chairman of the Securities and Exchange Commission, said in congressional testimony Thursday that he and other regulators have learned many lessons, chiefly that "voluntary regulation does not work." Apparently Cox urged Congress to fill "regulatory gaps" that are still putting the economy at risk. "The lessons of the credit crisis all point to the need for strong and effective regulation, but without major holes or gaps." Cox said Congress should appoint a select committee to address the challenges of regulation on a comprehensive basis.

Alan Greenspan, former Fed chief, admitted he made a mistake in trusting the free markets to regulate themselves. Alan Greenspan said: 'I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.'


Where they really that naïve?

Apparently voluntary regulation does not work. That's a big surprise there, isn't it? Voluntary regulation is very much like asking a tiger to consider the implications of his hunting habits on the deer population. It's simply against his nature. Without proper enforcement will never work. They might as well have sent an email to financial institutions reading: we know you can make a lot of money but please take the time to stop and consider the possible unpleasant implications you making money might have. Oh and by the way invest millions of dollars in risk management sophisticated enough to actually manage the risks you're taking.

It's never that simple though. Regulators basically expected financial institutions to be professional enough to care about their own survival and to invest proper capital and effort into adequate risk management which should ultimately lead to a better competitive position in the market.

A financial institution which has the ability to manage its risks better can also properly price credit given thus asking for a higher risk premium from more risky clients. These clients, in turn, will obviously shop around for cheaper rates naturally offered by banks that lack the ability to properly price risks. The latter banks, in theory, should be the first to crumble under crisis.
The problem is that no CEO of a financial institution can afford to get left behind while other are cleaning up on the securitization of subprime mortgages and other exotic derivatives which apparently no one really understood.

Surely senior regulators understand how things work

In short, they do. We can't and mustn't trifle with these outstanding individuals who have obviously shown considerable talent and ability to get to where they are. What happened then?
I believe that much like other painful surprises the current crisis is a result of a certain conception of reality proven wrong. I believe the reasons behind the failure of intelligence and law enforcement agencies at 9/11 are similar in many ways to the reasons behind this crisis. When a certain concept or conception have taken place and hold over a group of people, from a couple to a country and the world, it is very difficult to break away from it.

Voluntary regulation, as a concept, has a lot of reason behind it as I explained earlier. The human mind has a tendency to let sleeping dogs lie and mark a big v sign on things that don't really need to be discussed again.

This sort of groupthink is common to many aspects of human lives. That is also why I hailed the Socratic Method in my previous post on the Gone Fishin' Portfolio.

I hold a deterministic point of view on life. I don't really believe this crisis could have been avoided as many many different streams converged into the river that is the credit crunch. Many smaller and bigger failures has to happen for a massive boom like this to happen.
Now that it has happen we are all experts in what should have been done and what needs to be done but all we are doing is preparing for the previous war when the next one will surely surprise us as well.

Related Posts:

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• From a Financial Crisis to a Real Crisis: The Makings of a Greek Tragedy?
• The Credit Crisis Presents a Rare Opportunity for Learning and Experience
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• How to Invest Wisely In a Bear Market?
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Image by: Queen roly

Do you understand investment risk?

Talk of investment risk is abundant but what is investment risk really?

Stock investments are risky; Investing in corporate bonds is less risky but still carries some risk; Investing in government bonds is risk free; we each have our own risk preferences and should invest accordingly, and so on and so forth.

We all know and recite these market truths by heart. But do we understand investment risk for what it is?

Investment risk is often defined as “The volatility of returns. Generally, the higher the potential return over time, the higher the level of risk involved” (BT financial group).

Essentially, a riskier asset means the asset’s returns are more variable. The economic risks which are responsible for this volatility make good subjects for a series of different posts. Suffice to mention the following as sources for varying volatility of returns in different financial assets: Operational risk, financial risk, credit risk, market risks, geographical risks and more (endlessly more). Whatever the source, the result is volatility in the returns of a certain financial asset.

Alright, volatility in returns is still not clear enough: what does that translate into?

In finance volatility of returns of a certain financial asset is measured by the statistical tool of standard deviation. Before you run away to the sound of statistics let me explain how easy and intuitive this is. Standard deviation measures statistical dispersion or how widely the values, in this case, returns are spread. By calculating an average return for a certain stock and calculating the differences between this average and the actual returns over time we learn how volatile or how widely spread the results actually are. If results are close to the mean or average then the volatility is low. If they are widely spread then volatility is high. Here’s a short example of how standard deviation is calculated (notice we take the square of the spread from the average. That is done so negative and positive results will add up instead of cancel):


In this example 6 out of 12 returns fall within 1 unit of standard deviation from the average (+10%, - 10%). Another financial asset might display higher or lower volatility, or distance from the mean. The higher the volatility of a financial asset the higher the risk we attribute to it.

Government bonds will display lower volatility as the interest rates is government assured. These financial assets will be less influenced by the economic environment and will guarantee return if you hold on to the asset until payment. A stock will display higher volatility as it is more sensitive to the economy and all those risks we discussed earlier. Each influence will be translated to price shifts which increase the overall volatility of the stock.

Why is higher volatility associated with higher investment risk?

An obvious yet often overlooked question. The basic premise in this case is that as individuals we require a certain level of certainty for our future wealth which is translated to utility. Higher volatility implies a higher level of uncertainty and lower utility from a specific investment. Therefore higher volatility is translated into higher risks and in turn we demand a higher compensation for the risk taken in the form of higher returns.

How to we determine the level of return we require for the risk taken is a whole other story. If you find this subject matter interesting please let me know.

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Uncertainty and Risk differentiated – Is a Tactical Surprise Preferable to a Strategic Surprise?

Risk management is a relatively new and evolving field. Risk management usually refers to the process of identifying, measuring, controlling, and minimizing uncertainties which may directly or indirectly affect a desired outcome of a system. A great challenge indeed.

Any process or procedure we can think of holds many uncertainties. Risk management tries to identify these uncertainties, assign probabilities and possible harm to each and every one and acts to minimize those risks.

One of the most counter intuitive questions in risk management basics is: What is the difference between risk and uncertainty? There are actually many differences; some are of the utmost importance to every organization and every manager.

When every possible option and outcome is known a decision is said to be taken under certainty. Many academic models assume certainty due to their basic function of explaining and prediction. These are also the standards most models are judged by. The recent retreat from certainty in academic modes has been due to explanatory gaps.

What is uncertainty then? Uncertainty is a situation in which possible outcomes of an action or decision are known but their probabilities are unknown or can not be assigned to each and every outcome. At this point intuitions should be baffled. What is risk then?

Risk is a situation in which possible outcomes of an action or decision are known and their probabilities are also known. What’s the difference? Risks can be identified, measured, insured against and minimized.

For example, insurance companies have very detailed statistics of accidents, thefts, earthquakes and even loss of limbs of famous and gifted football players. These are all risks. Uncertainties are also everywhere but can not be measured and as a result insured against. For example, who’ll be the next president of the US? That is quite a significant uncertainty.

However, the greatest significance of this differentiation between risk and uncertainty is their role in management. When all possible outcomes have probabilities assigned to them the biggest possible surprise for a manager is a tactical surprise.

For example, a fire might consume a warehouse but it can be rebuilt by insurance money or prevented by installing a sophisticated auto extinguisher.

When outcomes can not be assigned probabilities there is a chance of a strategic surprise. This is very dangerous for an organization as it might impact it in unforeseen ways. A certain legislation might pass which severely limits the organization’s ability to compete, a new technology may appear which will render the organization obsolete and much more.

Dealing with uncertainties is a manager’s duty which requires constant strategic thinking and evaluation. In order to better deal with uncertainties risk management practices should be put to use in strategic thinking as well and not just n operations and finance procedures where they are more common.

Risk Management – Pure Risk and Speculative Risk Explained

Risk management is a relatively new and evolving field. Risk management usually refers to the process of identifying, measuring, controlling, and minimizing uncertainties which may directly or indirectly affect a desired outcome of a system. A great challenge indeed.

Any process or procedure we can think of holds many uncertainties. Risk management tries to identify these uncertainties, assign probabilities and possible harm to each and every one and acts to minimize those risks.

Two of the most basic terms used by risk managers are pure risks and speculative risks. All risks are historically associated to one of the two families. Understanding the motivation and reason behind this differentiation is key to taking your first steps in risk management.

Every risk is at its base a known series of possible outcomes with possible benefits or harms. Each possibility has a known probability of realization (otherwise it is not a risk but an uncertainty and is dealt with differently).

Pure risks are a family of risks in which all possible outcomes are harmful in some way. In other words a pure risk is a situation that can only end in a loss. For example, the risks of an accident, a car theft or earthquake are pure risks.

Speculative risks on the other hand are a family of risks in which some possible outcomes are beneficial. In other words a speculative risk is a situation that might also end in a gain. For example, the risks of stock investment or business venture are speculative risks.

This differentiation between families of risks is very important as each family has its own distinct features. Pure risks are characterized by the following:
1. Small chance of occurrence – The probability associated with risk occurrence is small.
2. Grave results – In case of risk occurrence the results are significant.
3. Instant impact – The impact of risk occurrence is instant.

Let’s reconsider pure risks such as an earthquake, a car theft or an accident. These risks have a relatively small chance of occurring, all have grave results and their impact is instantaneous.

Another less mentioned but very important characteristic of pure risks is the fact that these risks do not present themselves due to the small chance of occurrence. There are virtually endless amounts of pure risks around us. One can come up with infinite pure risks by thinking of every process. A boulder might roll on to you when you brush your teeth. Sure, there’s a small chance that might happen, but it’s there. We overlook pure risks because of those small chances.

Speculative risks are basically all other risks. These risks are dynamic and changing (pure risks are more static due to their nature). Speculative risks have been traditionally dealt with in the confines of financial management. Modern risk management deals with these kinds of risks as well as their impact might be as significant as that of pure risks.