Behind AIG's Fall, Risk Models Failed to Pass Real-World Test - WSJ.com

Behind AIG's Fall, Risk Models Failed to Pass Real-World Test - WSJ.com

A great article about AIG reckless underwriting of credit default swaps. The article is a great illustration on the difference between risk and volatility. I have argued this difference in several posts and I still believe that a lot of investors, even professional, as illustrated by this article, confuse risk and volatility.

Several take away from the AIG case:

1. Models do not articulate risk, they articulate volatility.
2. Common sense and conservative policies go along way in protecting capital.
3. Historical data should not be relied on for investment decisions entirely; it can always be manipulated to show whatever case you want them to show.
4. Good and conservative management matter much more than assets and technology.

What is Risk?

A discussion about risk and return came up in the comments section of a blog, which gave me the idea to put my thoughts on the subject in this post.

Majority of investors talk about risk and return in the same breath, the saying goes " no risk no return". I find that one of the most erroneous terms coined by Wall Street, and there are many of them. Actually the way I see is by limiting my risks, I will earn above normal returns.

Investors should distinguish between risk and volatility. Volatility is backward looking and pertain to price movements day-to-day, it is actually defined as the standard deviation of prices around their historical mean. There is not much insight from that figure, if any, to your investment decision making process.

However, Risk in investing should be future looking in nature and not backward looking as volatility. Price movements and historical financials bear little on an investment's risk profile. One thing is clear in my mind Risk does not equal volatility and more certainly risk does not equal more returns. Wikipedia defines risk as:

.... a concept that denotes a potential negative impact to some characteristic of value that may arise from a future event, or we can say that "Risks are events or conditions that may occur, and whose occurrence, if it does take place, has a harmful or negative effect". Exposure to the consequences of uncertainty constitutes a risk. In everyday usage, risk is often used synonymously with the probability of a known loss.

And it is calculated as:

Risk comes from the assessment of the company operations and economics accompanied with probable future adverse scenarios that the business might endure. Your analysis of these scenarios and their affect on the financial health of the business is how you assess how risky a business is. I try to find businesses that have limited probable risks associated with their operations. In this case more risk does not mean more return, it actually means exposure to more possible losses, which I am certain most investors want to avoid.

The example best used with the saying "more risk more return" applies to choosing between various types of asst classes, for example money market vs bonds vs stocks. Wall Street argues that with stock you will make more returns due to more risk involved with owning equities. To illustrate my point how erroneous that saying is, I ask you which asset will you hold: a GM bond or P&G common stock?

Risk vs. Uncertainty

I tend to evaluate and buy risk but I ignore uncertainties when thinking about equity valuation. The difference between the two is subtle yet very important. The market tend to hate and avoid both, which can create opportunities. The current market situation contains a lot of uncertainty and risks as well. I am willing to take on risk in face of uncertainty while many investors are willing to take neither and that's why you see treasuries are yielding negative real returns.

Uncertainty, in my mind, is when you can't articulate a set of finite scenarios and attach a probability to those scenarios. Risk, on the other hand, is where an intelligent investor can outline a set of outcomes with expected probability of occurrence. With this definition in mind, the uncertainties facing the investment environment in the short run today are :

• Political uncertainty : who wins the US election, what kind of tax regime will be instated, fiscal budget management ...etc. All these issues are uncertainties as you can't pin point accurate outcomes with realistic attached probabilities.
• Economic uncertainty: the rise and fall of economic activity and which sector is under pressure, job loss ...etc are another set of uncertainties that companies or investors have no control over nor can they do anything about.
• Financial bankruptcy uncertainty: you do not know who will it be and what will be the impact. It could be a benign event if some small regional bank went under or even a big investment bank. The impact is not quantifiable so it is uncertainty for me.
• Regulatory uncertainty: with the introduction of new banking regulation, its impact on financial is uncertain as the details of these regulation are unclear.

So what kind of risks in the short term are facing the markets:

• Credit risk: There are a lot of credit risks and issues that face certain sectors more than others. The Banking sector faces more credit risk than any other sector due to its nature. There are risk in commercial real estate defaults, although as I wrote before I think it will be benign. There are increasing consumer loan defaults and mortgage ARM resets that can lead to more write downs. You can attach an estimate of $100- 200 Billion in write downs for this risk.
• Inflation risk: This has become more acute in recent periods. An increase in inflation will reduce your real return so once factored in your analysis it will affect return expectation.
• Earning risk: the risk of decline of corporate earnings has increased with slowing economy. This risk will lead to lower valuation of equities.

However in face of these risks there is an upside :

• credit improvement: there are signs of thaw in the credit market. You can see a lot of risk spreads coming down as well as a lot of the credit default swaps on banks have declined significantly. If credit environment improve you can see a lot of upside in bank earnings as a lot of the write downs will become write up.
• Cash has been accumulating in money markets and low yielding treasuries; the question is how long will investor be satisfied with meager returns before they accept risk? These funds can give a boost to equities and other depressed asset classes like real estate.

Given these risks I think there is room for an opportunity in the most beat up and distressed areas of the market that being banks, retailers, real estate and credit instruments. If you have been following my posts and investment you can see that I have bought the risk into these areas in face of the uncertainties that the market is worried about. Risk vs uncertainty is an important distinction. Knowing which is which can allow the investor to earn good return.

Pricing Risk II

Risk planning, in my opinion, is the only thing investment should be about. Success in investment is about risk management and assessment more so than picking good ideas. In my view there are 4 types of risk:

1. Business specific risks: where you lose because of management incompetence, increased competition, and financial insolvency.
2. Valuation risk: there is an adage that says "not all good companies make good investment". This means that you can find an absolutely great management, fantastic product, great prospect, and good sustainable competitive advantage. So where is the risk? The company is overvalued by investors leaving no room for good return and little margin for error.
3. Systemic risks: these risks are general economic risks that are not unique to one company but rather impact most companies to one degree or another.
4. Your own liquidity risk: there may be circumstances that could force you to sell great undervalued businesses prematurely at depressed market prices, therefore you realize losses.
   

All of these risks are present in any investment you make. Realizing their existence and planning for them is as important as researching and analyzing any business idea.

Risks # 1 and # 2 are under your control entirely by performing prudent due diligence you can eliminate these risks. Some will argue diversification can illuminate them as well, sure it can but it comes at the expense of your portfolio performance. I would rather invest my time to analyze and research one great company rather than buy two average businesses. And to avoid #2 simply do not overpay. Avoid companies that are in the headlines news or the ones that your annoying brother in law recommends to you.

Risk # 3 is outside of your control but you can plan for it nonetheless. You can have a good asset allocation mix between equities, bonds, and real estate to diversify this risk as generally in rescissions bonds tend to do better than equities.

Risk # 4 sometime no matter how you plan for it, it will happen but again you can minimize this by only investing the sum of money that you can do without for indefinite amount of time. You should not invest if you are running a startup business, or your foresee you need capital for an upcoming financial obligation. Any investment should be made with the assumption it is forever.

Risk and investment is two faced coin. You have to be able manage both well to succeed.