Views of Risk
Traditional Economic View
• Thűnen [1826]
– Profit is in part payment for assuming risk
• Hawley [1907]
– Risk-taking essential for an entrepreneur
• Knight [1921]
– Uncertainty non-quantitative
– Risk: measurable uncertainty (subjective)
– Profit is due to assuming risk (objective)
Contemporary Economics
• Harry Markowitz [1952]
– RISK IS VARIANCE
– Efficient frontier – tradeoff of risk, return
– Correlations – diversify
• William Sharpe [1970]
– Capital asset pricing model
• Evaluate investments in terms of risk & return relative to the market
as a whole
• The riskier a stock, the greater profit potential
• Thus RISK IS OPPORTUNITY
• Eugene Fama [1965]
– Efficient market theory
• market price incorporates perfect information
• Random walks in price around equilibrium value
Empirical
• BUBBLES
– Dutch tulip mania – early 17th Century
– South Sea Company – 1711-1720
– Mississippi Company – 1719-1720
• Isaac Newton got burned: “I can calculate the motion
of heavenly bodies but not the madness of people.”
Modern Bubbles
• London Market Exchange (LMX) spiral
– 1983 excess-of-loss reinsurance popular
– Syndicates ended up paying themselves to insure
themselves against ruin
– Viewed risks as independent
• WEREN’T: hedging cycle among same pool of insurers
– Hurricane Alicia in 1983 stretched the system
Black Monday
• October 19, 1987
• Stock Exchange – triple witching hour
• Some blamed portfolio insurance
– Based on efficient-market theory, computer
trading models sought temporary diversions from
fundamental value
Long Term Capital Management
• Black-Scholes – model pricing derivatives
• LTCM formed to take advantage
– Heavy cost to participate
– Did fabulously well
• 1998 invested in Russian banks
– Russian banks collapsed
– LTCM bailed out by US Fed
• LTCM too big to allow to collapse
Information Technology
• 1990s very hot profession
• Venture capital threw money at Internet ideas
– Stock prices skyrocketed
– IPOs made many very rich nerds
– Most failed
• 2002 bubble burst
– IT industry still in trouble
• ERP, outsourcing
Real Estate
• Considered safest investment around
– 1981 deregulation
• In some places (California) consistent high rates of
price inflation
– Banks eager to invest in mortgages – created tranches of
mortgage portfolios
• 2008 – interest rates fell
– Soon many risky mortgages cost more than houses worth
– SUBPRIME MORTGAGE COLLAPSE
– Risk avoidance system so interconnected that most banks
at risk
APPROACHES TO THE PROBLEM
• MAKE THE MODELS BETTER
– The economic theoretical way
– But human systems too complex to completely
capture
– Black-Scholes a good example
• PRACTICAL ALTERNATIVES
– Buffett
– Soros
Better Models
Cooper [2008]
• Efficient market hypothesis
– Inaccurate description of real markets
– disregards bubbles
• FAT TAILS
• Hyman Minsky [2008]
– Financial instability hypothesis
• Markets can generate waves of credit expansion, asset inflation,
reverse
• Positive feedback leads to wild swings
• Need central banking control
• Mandelbrot & Hudson [2004]
– Fractal models
• Better description of real market swings
Fat Tails
• Investors tend to assume normal distribution
– Real investment data bell shaped
– Normal distribution well-developed, widely understood
• TALEB [2007]
– BLACK SWANS
– Humans tend to assume if they haven’t seen it, it’s impossible
• BUT REAL INVESTMENT DATA OFF AT EXTREMES
– Rare events have higher probability of occurring than normal
distribution would imply
•
•
•
•
Power-Log distribution
Student-t
Logistic
Normal
Correlated Investments
• EMT assumes independence across
investments
– DIVERSIFY – invest in countercyclical products
– LMX spiral blamed on assuming independence of
risk probabilities
– LTCM blamed on misunderstanding of investment
independence
Human Cognitive Psychology
• Kahneman & Tversky [many – c. 1980]
– Human decision making fraught with biases
• Often lead to irrational choices
• FRAMING – biased by recent observations
– Risk-averse if winning
– Risk-seeking if losing
• RARE EVENTS – we overestimate probability of rare
events
– We fear the next asteroid
– Airline security processing
Animal Spirits
• Akerlof & Shiller [2009]
– Standard economic theory makes too many
assumptions
• Decision makers consider all available options
• Evaluate outcomes of each option
– Advantages, probabilities
• Optimize expected results
– Akerlof & Shiller propose
• Consideration of objectives in addition to profit
• Altruism - fairness
Warren Buffett
• Conservative investment view
– There is an underlying worth (value) to each firm
– Stock market prices vary from that worth
– BUY UNDERPRICED FIRMS
– HOLD
• At least until your confidence is shaken
– ONLY INVEST IN THINGS YOU UNDERSTAND
• NOT INCOMPATIBLE WITH EMT
George Soros
• Humans fallable
• Bubbles examples reflexivity
– Human decisions affect data they analyze for future
decisions
– Human nature to join the band-wagon
– Causes bubble
– Some shock brings down prices
• JUMP ON INITIAL BUBBLE-FORMING
INVESTMENT OPPORTUNITIES
– Help the bubble along
– WHEN NEAR BURSTING, BAIL OUT
Nassim Taleb
• Black Swans
– Human fallability in cognitive understanding
– Investors considered successful in bubble-forming
period are headed for disaster
• BLOW-Ups
• There is no profit in joining the band-wagon
– Seek investments where everyone else is wrong
• Seek High-payoff on these long shots
– Lottery-investment approach
• Except the odds in your favor
Taleb Statistical View
• Mathematics
– Fair coin flips have a 50/50 probability of heads or
tails
– If you observe 99 heads in succession, probability of
heads on next toss = 0.5
• CASINO VIEW
– If you observe 99 heads in succession, probably the
flipper is crooked
• MAKE SURE STATISTICS ARE APPROPRIATE TO
DECISION
CASINO RISK
• Have game outcomes down to a science
• ACTUAL DISASTERS
1. A tiger bit Siegfried or Roy – loss about $100 million
2. A contractor suffered in constructing a hotel annex,
sued, lost – tried to dynamite casino
3. Casinos required to file with Internal Revenue
Service – an employee failed to do that for years –
Casino had to pay huge fine (risked license)
4. Casino owner’s daughter kidnapped – he violated
gambling laws to use casino money to raise ransom
DEALING WITH RISK
• Management responsible for ALL risks facing
an organization
• CANNOT POSSIBLY EXPECT TO ANTICIPATE ALL
• AVOID SEEKING OPTIMAL PROFIT THROUGH
ARBITRAGE
• FOCUS ON CONTINGENCY PLANNING
– CONSIDER MULTIPLE CRITERIA
– MISTRUST MODELS