Stress Testing As a Distinction Between Clairvoyants and Risk Managers

Stress Testing As a Distinction Between Clairvoyants and Risk Managers

Bill Graham, the father of value investing and the co-author of the infamous book Security Analysis, said: “The essence of investment is management of risk, not management of returns”. This was postulated in the middle of the last century, and today risk management is no longer an exclusive province of quants. It is used by financial advisors, since advisors are de-facto risk managers who balance their clients’ investment goals against the investment constraints, searching for and implementing the suitable portfolio solutions.

But why has risk management failed so dramatically in 1998, 2000, 2007, 2008 and again in 2010 with the European debt crisis? We will argue that too much focus has been placed on backward-looking risk measures and not enough on scenario analysis.

Risk Management is not Clairvoyance and Market Timing

But what is risk management anyway? While almost everyone uses the words ‘risk management’, the implied meaning seems to differ from person to person and from advisor to advisor. Let’s start by discussing what risk management is not. Risk management is not about:

– being a clairvoyant
– forecasting specific future events
– timing those events i.e. ‘the big short’

Risk management is about finding the suitable risk/return profile for the holder of the portfolio. When your client has a suitable portfolio, he or she will not sell when the losses hit, because the possibility of those losses was discussed right from the beginning of your relationship. The biggest problem for most investors is that they get in near the top and get out near the bottom. ‘Suitability’ ensures that this vicious circle is disrupted. If your clients don’t get out at the bottom, then they won’t have to jump back in at the top. But the only way that could happen if their risk/return tradeoff was chosen by considering a variety of scenarios: good, bad and ugly. Showing low risk simply because the realized volatility is low and VIX is heading toward single digits cannot really be called risk management. That is called rear view mirror driving.

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