One of the go-to formulas of horror movies is to try to avert the audience’s (and character’s) attention away from the real risk. Someone hears a noise in a (supposedly) empty room, they walk in and see an open window. The unfortunate character starts focusing on why the window would be open, maybe even leans out the window and starts looking around. At some point, the character is satisfied that the open window is no longer a threat (whew!), closes the window, turns around, and BAM! You find out the real risk came in through the window and was hiding in the room. Now, the settings and characters change (why don’t we try having a group of sharks caught in a tornado?), but the formula remains the same.
Similarly, investors can sometimes get caught focusing on certain risks, while it’s often the ones they’re not focused in on that cost them the most.
One of the most widely used ways that investors look at risk is the standard deviation of an investment. Harry Markowitz won the Nobel Prize largely on his work on Modern Portfolio Theory (MPT), which defines risk as standard deviation. The standard deviation gives you a basic measure of how volatile the return stream of an investment has been (or is expected to be), and is extremely useful in getting an understanding of what to expect in a normal environment.
MPT took the concept of risk further in recognizing that the correlation of investments in a portfolio is also important, that the combination of investments with a low or negative correlation to one another can create an outcome where you can get a higher level of return for a given level of volatility. This enabled investors to create an “optimized portfolio,” which was the best possible mix of investments to maximize your return for a given level of risk.
The problem with this is that we don’t live in a normalized world, where return distributions are symmetrical and correlations between investments remain constant. 2007 and 2008 were shining examples of that. Quantitative strategies that had been effective in a “normal” environment collapsed when price moves that they had viewed as “once in a million year events” started occurring with regularity. Optimize all you want, but if you owned an investment vehicle backed by Lehman Brothers you probably didn’t have a good outcome, even if you were on the right side of the trade. And not many people factored in the possibility of their money market fund breaking the buck, as happened to the Reserve Fund.
So, what’s the solution? Diversification. Inevitably you’ll find your investments adversely affected by some kind of risk; however, with proper diversification just part of your portfolio will be affected rather than the entire thing. But while the MPT concept of diversification starts you in the right direction, it doesn’t check all the nooks and crannies where danger might be lurking.
Thinking about how asset classes would react under different scenarios or events helps you to better protect your portfolio. Entering 2007 most investors would have thought commodities were good hedges against a stock market decline. Commodities had done very well in 2000-2002 when the tech bubble burst, and touted a negative correlation to stocks over most trailing periods, a huge consideration when optimizing a portfolio using MPT. But when a deep recession caused consumption and production to plummet, commodity prices dropped right along with stocks, leaving many investors scratching their heads. The credit crisis did that to nearly all asset classes with any level of risk associated with it, leaving the only winners investors in high quality bonds and a relatively obscure (at the time) strategy called managed futures.
The lesson is clear. There are times when “normal” becomes abnormal and the way asset classes interact with one another changes. So while checking the open window in the empty room might be the right thing to do 99% of the time, it pays to be on the look-out for the monster in the closet.