Risk through Coloured Glasses

When I studied economics a long time ago, one of the definitions that stayed was that risk is measurable while uncertainty is not. Probably at that time I did not get the full import of either this or the Efficient Market Hypothesis (EMH) and the ubiquitous ceteris paribus conditions.

Progressively, the idea of risk kept changing shades. In a trading situation, it was quite clear that the aggregate exposure and the extent of the stop-loss permitted define the scope of the risk that one can carry. This was of course a strait jacketed but practical way of looking at risk. Impact costs, illiquidity and gap-open risks etc were hardly noticed unless one happened to be on the opposite side of say Soros in Stg.

In a portfolio setting, the concept of risk has started acquiring new dimensions. For instance, would you look at market risk if the accounting standard allows a hold to maturity treatment and does not insist on a MTM? One may tend to reclassify or restructure such holdings if they turn to profit but cold storage the same if out of money (Well; the new IFRS standards will make this inconvenient, but isn’t a dilution being contemplated here?). On the other hand, can we visualize situations wherein an accounting treatment introduces volatility in the earnings and hence presents a new class of risk? Or for that matter, is the accounting ability/affordability to book a loss, a separate risk in itself? In other words, in trying to avoid booking a loss in the interests of current income, do companies continue to hold on to a potentially (further) losing position?

The events of 2008 have thrown up other dimensions of understanding risk. For instance, there was little or no risk diversification with all markets shooting up and falling hard together. The issue of private gain vs public loss and the consequent too big to fail concept presented the biggest ever moral hazard for central bankers. And this itself is a result of another moral hazard perpetrated by the major central bankers during the last couple of decades viz., reflate or print your way out of each economic problem

Amongst all these, the risk shade that fascinates me the most is the subject’s perception to the market risk. Once you go thru couple of boom-bust cycles, you realize that risk perception is by and large asymmetrical. In boom/bubble/mania times, there is a blindfold on perception and treatment of market risk. In fact, the organizational risk lies in not running major positions with the pack since everyone will be making money at a perceived low risk. Lowenstein in his book on LTCM quotes the incident of a Lehman executive losing his job for suggesting that Wall Street top managements did not understand the risk carried by the traders. I know the case of a trader heading the proprietary book of a major bank losing his job because of his contrarian style (who ran the positions against the market towards the tail end of the market move). His successor is still booking profits from the legacy positions.

Another dimension closely linked to perception is the extent of leverage. Typically during and towards the end of the boom time, the tendency to increase positions is the highest. At the other end of the spectrum, panic situations are times for cleaning up operations while the fat tail kills all risk appetite. The self or organization induced tendency is to reduce positions to the bare minimum. A rare few may redeem themselves (if they hung on with light positions or better still bailed out much earlier or best still gone against the market in the nick of time).

One of my ex-bosses used to say that in order to successfully deal in the markets, you need to fight yourself. May be he should have added that you need to fight yourself and just about everyone else. Well, not at all times or frequently (in which case being a routine contrarian becomes a huge risk than going with the flow!); but after a significant market move where you tend to either throw caution to the wind or totally abstain from market. If this is a tough job for an individual; it is a huge dichotomy for the organization. A time when the organization is super bullish is the time when it ought to be careful! How can an organization reconcile to this phenomenon? How can organizations be made to shed hubris and consciously develop an ability to stand against the tide at crucial junctures?

The fact that risk is a subjective perception that is influenced by market sentiment is well documented; however very few factor for the same in managing their market risk. Can risk be modeled to include the asymmetry of perception at both the extremes? Can the extreme be defined ex-ante by defining an objective set of behaviour parameters? Do the time cycles or chaos theories or Elliott wave or a combination of all these help in building such a model? If done would it then lead traders to time the markets or put it differently manage risk in the process of taking risk itself?