On Risk
Many investors bristle at the notion of risk being reduced to a measure of volatility. They think of risk as the likelihood of permanent capital loss. Our fundamental roots empathize with this view. Risk is unknowable in the present, and at best is extrapolated based upon the past. Or as Howard Marks wrote, “there’s far too much randomness in the world for future events to be knowable. [1]” At Epsilon, we have studied the missteps of historical quantitative blow-ups. These cautionary tales involved an overreliance on an exacting quantification of risk, frequently based upon empirical historical data and assumptions regarding distributional normality.
These approaches invariably led to the accumulation of latent incalculable risks, which are ever-present in markets. That build up is usually fueled by hubris or greed, which shows up most often as leverage. This has put a stain on the practice of the quantification of risk through historical observation and its subsequent statistical modeling.
And yet, any acolyte of Marks’ school of thought[2] agrees that events do occur in probabilistic fashion. Risk is due to the unknowability of future events, but these events are not purely random. They can be homed in on through probability functions. Or as a wise investor once put it, “volatility is a useful proxy for uncertainty.”
Risk is unknowable in the present, and at best is extrapolated based upon the past.
By intelligently integrating a probabilistic framework for uncertainty into our portfolio construction, we can at the very least tilt the odds in our favor. Proxying risk with quantifiable measures such as historical volatility or options-implied volatility allows one to harness the value of probabilistic thinking. The key is to do so with a rational humility about the limits of precision. With that humility, we can stay grounded in realistic and sensible guidelines.
Guidelines vary as clients’ needs differ widely. To give you an example: the notion of risk for a highly diversified institutional investor with a permanent capital base is almost always failing to meet a future return objective, rather than permanent capital loss. Such institutions must invest in asset classes such as venture capital that intrinsically contain the probability of permanent capital loss in any one given investment. But these investments are diversified, as are the investments across the asset class (and across all asset classes). The culmination of all ingredients is reduced to a probabilistic outcome best suited for the time horizon and ultimate objectives of the investment plan[3].
Once we accumulate the entire distribution of possible outcomes for each underlying investment, we realize that underperformance occupies the vast majority of our uncertainty. This may be the antithesis of risk for an individual whose net-worth is largely tied to the illiquid stock of their employer, or the value of their home. Permanent capital loss is quite real given the overt concentration of their wealth and a diversified retirement account is often a panacea for de-risking that individual’s objectives.
Ultimately, the portfolios we offer are designed for investors with different risk-return objectives, and different aggregate portfolio needs. We ascribe to both ends of the philosophical spectrum of risk: the quantifiable and the unknowable. We believe each can mutually benefit the other and their application must ultimately be tailored to the needs of the client.
[1] Marks, Howard. Oaktree Memo, “Risk Revisited Again”, June 08, 2015.
[2] which in some ways incorporates the thinking of Peter Bernstein or Nassim Taleb
[3] A great way of thinking about this would be through the application of the Kelly Criterion for sizing binary bets.
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