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 ModelsCooper [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 million2. A contractor suffered in constructing a hotel annex,

sued, lost – tried to dynamite casino3. 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