Risk and the never-ending battle for investment survival

Investors are always concerned about risk particularly in times of market uncertainty or volatility. The “Value at Risk” (VaR) calculations that banks and other institutions developed in order to determine how much could be lost in the bank's trading positions on any given day is based on historical volatility of markets. However, once financial crises hit it becomes evident that losses can be much greater than the what the models predicted.

Although the theory of a bell-shaped curve distribution sounds good, the reality is that markets often do not obey those theories. Investors can be lulled into feeling secure when markets are moving up steadily and volatility is decreasing. At such times it is tempting to pile more money into the markets, thus causing them to continuously climb and exhibit low volatility. However once the trend is broken and a “black swan” event takes place volatility can skyrocket as the market gyrates up and down violently.

A brief history of risk reduction

Derivatives are not a new phenomenon. In fact they have been around since the beginning of trading, originally created to reduce uncertainty or risk. When a buyer of, say, grapes agreed to buy from a farmer in the future when that farmer had his harvest a derivative was created.

A buyer wanted to fix the price he would pay for a certain product at a future date so he could adequately plan, while the seller also wanted to fix the price so he could expect a given income in the future. But as the market grew, gaming entered the picture so investors not necessarily interested in the actual transaction wanted to bet instead on the outcome of certain transactions. 

The growth in derivatives popularity and complexity has been dramatic. Securities that derive their value from something else amount to over $500 trillion according to the Bank for International Settlements.

As the creativity of gamers and investors know no bounds, there are now any number of derivatives covering a wide range of operations and not necessarily products. 

There even exists an index on volatility itself and a number of derivatives opportunities around it. The Chicago Board Options Exchange’s VIX index measures the expected volatility of the US stock market over the next 30 days as indicated by option prices. The theory is with the index you are measuring the level of investor anxiety since the theories of the “Efficient Market” define risk as volatility.

Measuring risk

Harry Markowitz, who developed so-called “modern portfolio theory”, published an article in 1952 that argued investment returns should be judged against the amount of risk taken. Of course the concept of risk was too vague and difficult to measure so he used volatility, or variance, as a proxy for risk. So if one particular stock or index was more volatile than others, investors should expect better returns in order to justify the increased “risk”. He won the Nobel Prize in 1994 for his theories.

Following on this, William Sharpe, another Nobel prize-winning economist and a disciple of Markowitz, developed the Sharpe Ratio. This ratio compares the returns of the fund manager to the volatility of his performance subtracting the returns of a risk-free asset such as cash. 

Risk endurance

The application of these theories has not resulted in a magic formula for consistent, excellent returns for investors but at least they give us some theoretical measures we can use in the never-ending battle for investment survival.