nathan-dumlao-432134.jpg

Risky Business

The Focus, A Brandes Publication, 2008

"It’s not what you don’t know that’ll hurt you; it’s what you do know that just ain’t so."

"It’s not what you don’t know that’ll hurt you; it’s what you do know that just ain’t so."

-Mark Twain

In the quote above, Twain probably wasn’t talking about managing client portfolios, but his folksy wisdom certainly applies to risk – how it’s measured and managed. In general, we believe popular perceptions of risk are not only wrong, but can damage wealth accumulation efforts. For example, 40% of institutional investors use standard deviation to measure risk, and another 30% use measures such as beta, Sharpe Ratio, or information ratio – which are based on standard deviation.

In our opinion, these popular definitions of risk “just ain’t so.” In fact, we believe these perceptions lead to “risk averse” investment strategies that often result in poor manager selection, poor results, and client discontent. Why? When building client portfolios, prevailing sentiment suggests that “risk management” means chasing managers with a recent history of low volatility and high alpha. We disagree – primarily because of how we define risk. We don’t believe risk is synonymous with volatility. In fact, we think volatility should be embraced as potential opportunity. Later in this piece, we’ll address how. First, to better understand how the investment industry has become focused on volatility as risk, we examine key developments in the history of risk measurement.

Read Full Article