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Avoid Building Towers of Risk on Unstable Grounds

Yannis Sardis, 9 March 2021

Fragility is the quality of things that are vulnerable to volatility.”
Nassim Nicholas Taleb
, Trader, Author and Scholar on Uncertainty.

As young children, most people have spent countless game-hours to construct towers with building blocks. In our effort to surpass our friends-competitors, our towers were getting ever-taller and thus wobblier to the point of destruction. In conjunction with its fun value, this game also unconsciously introduced us to the concept of risk management, namely the continuous trade-off that we must employ to achieve height (performance) and stability (preservation).

The history of financial market crises as well as the level of current asset valuations, may however indicate that investors do not always recollect the potential drawdowns introduced by a game of multiple expected outcomes falling out of balance between its expected targets and risks. Stocks at record high valuations, bonds yielding next to zero and people wishing to become successful investors overnight, keep forcing large capital inflows into various asset classes and instruments, in a relentless chase for higher performance at lower risks.

Our Disruptive Innovation culture

Who would not like a magic money machine which can produce attractive returns on unconventional assets, at lower risk than traditional portfolios and in a short period of time? The disruptive innovation culture of our times promises to not only change certain aspects of society to the better but to also produce a higher level of wealth equality by allowing everyone participate in the growth of the listed companies that most closely represent this cutting-edge technology and diverse field.

However, such a culture drives:

  • People who have little (or no) experience on investments to deploy their hard-earned capital on trendy assets which they most often have done little analysis on
  • Investors to trade, in massive amounts, various index-tracking securities (such as Exchange Traded Funds), which hold a collection of securities, and track a theme or a sector.

Although such a momentum allows one to tap into a vast set of new opportunities, it also incubates certain risks for one’s overall portfolio:

  • As the short-term correlations between such disruptive stocks (being viewed as a unified force behind a new movement) may increase quickly and substantially. Such correlation hikes may occur for no apparent fundamental reasons. For instance, the fact that Tesla decided to add USD 1.5Bn to its balance sheet may have been perceived by the untrained eye as a ‘reason’ for Tesla and Bitcoin being highly correlated (instead of an investor wondering what volatility such a move could introduce to Tesla’s earnings figures)
  • As the most popular disruptive-type Exchange Traded Funds may hold a large percentage of the outstanding shares of the underlying stocks, a fact that could cause pain to investors if these Funds suddenly faced large outflows. In such cases, the risk clustering unexpectedly caused by the increase in cross-correlations could propagate into a forced selling across the themes or sectors represented in the Fund’s composite portfolio.

The increasing clustering in portfolio holdings is reflected in a recent Charles Schwab survey, which noted that Tesla and Bitcoin are among the top five securities held by Millenials.

Risk-Adjust to avoid Capital Dislocations

The volatility-reduction policy mechanisms deployed by Central Banks, combined with collective market behavioural psychology (false stability) and investor inertia (Fear of Missing Out), should alert the diligent investor and money manager to undertake a frequent evaluation of a portfolio’s risk exposure to normal or Black Swan market conditions, by producing:

  • A risk decomposition analysis for an exhaustive list of categorisations such as asset class, sector, risk country, reference currency, credit rating and underlying security holdings, thus effectively identifying any unwanted asset concentrations, or equivalently any imbalances between individual position weights and their associated risk weightings
  • A stress-testing simulation framework, for assessing a portfolio’s tolerance to adverse market actions, via both past historical crises and customised disaster scenarios, so that investors can change a portfolio risk factor and the risk engine can calculate anew all cross-correlations, by placing a heavier weight on an asset’s most recent observations.

Investors would benefit, in the longer term, by testing the stability (risk-adjustment) of their portfolio tower before adding more building (performance-focused) blocks.

FINVENT Software Solutions is a trusted provider of financial software applications and custom engineering services. The award-winning KlarityRisk platform specializes in investment risk analytics and fixed income performance attribution reporting and it is offered to Private Wealth institutions, Asset and Hedge Fund Managers and Family Offices. Finvent is the sole SS&C Advent distributor worldwide and its products are integrated with those of SS&C Advent. Finvent is also a partner of FactSet, the integrated data aggregator platform.