It Is All About Risk Management

I am not one that usually likes to gloat, it tends to always be a precursor to losing money, but at times I feel for the sake of common good one must express their views in the most powerful way. Here is the reality, since 2005 I have not had a negative returning year. I am a macro investor, who has the fortunate position of being able to invest in a variety of liquid asset classes. Given I do not consider myself an expert economists or a quantitative genius, the question should be asked why I can do this when banks and other hedge funds could not. The only answer I can come up with, by analyzing myself as an investor, is I use a mixture of common sense and risk management. If we presume that common sense, given it is common, is not something that makes me special, it leads to the conclusion that what distinguishes me from the so called elite in the financial industry is risk management. Here I am referring not just too Chief Investment Officers, Portfolio Managers, Traders, Risk Managers but also Regulators. In fact the problem the world finds itself in economically is due to poor risk management from global regulators. Simply they did not set the appropriate risk capital boundaries for financial institutions. So lets focus on the way regulators view risk, which by the way is effecting how all institutions view risk. They believe an appropriate calculation of risk can be done by looking at a model that comes up with a number representing what an institution could lose over a given time for a certain probability. This is known as Value at Risk. One of the most important components of this calculation is a correlation matrix. In layman terms this number defines the so called relationship between 2 asset classes or positions. The simplest way to think about this is the old adage when equities go up bonds go down. In this case the two assets are negatively correlated. If we hold the same amount of these two and they move in exactly the same amounts with same velocity then they would be perfectly negatively correlated. In my view, this belief and reliance on this relationship is where regulators go wrong in setting the boundaries. You see asset classes, like bonds and equities are like people, they are influenced by many things and at different times what influences them changes in priority. Therefore you can not average or assume how they act over history, all you can do is make a best assumption for today. In fact if we look at the history of Value at Risk this exactly the view of the academics who first brought this model to the general public's attention. I suggest anyone interested should read Markowitz original paper on the subject. In fact the original way of using this model by a regulator was probably the best, known as the SEC model, it just asked bank to calculate how much they could lose over a given time for each asset class and then totaled the risk rather than using a correlation calculation. However this method was hijacked and developed to include a correlation matrix, and the SFA in the UK were the main proponents of this. As ever in life much of this was due to personalities. The SFA regulatory model team was led by an academic and practitioner called Dr Andrew Street. An extremely intelligent, yet arrogant individual. The team he headed were populated ultra intelligent indivduals yet none with any trading or market experience. A recipe for disaster.  SFA's development in using this correlation matrix resulted in lower capital charges for banks. Basle in Europe adopted this and hence when Basle II  rules, which codified this form of calculation of risk, came into print the US regulators had no option but follow or lose a considerable amount of trading in New York.  The story in reality has a few more sub-plots, which include JP Morgan's development of the model, known as RiskMetrics. I am more than happy to provide the details for private requests, however for the purpose of this article lets focus on the regulator.  So now Value at Risk, as promoted by global regulators, with its correlation matrix now becomes the standard for risk management in the finance industry. And yes was also the base for calculating structured credit risk. This leads into 2007 when of course the model proves complete ineffective to prevent the credit crisis. So what do I do that so different from a risk management perspective that has allowed to make money in all market environments. Well it starts with philosophy. I do not just view risk management as a way of assessing how much money I could lose. I view it from perspective how much money could I lose and what money do I have left after this calculated loss to make the loss back. You see by adding the latter to risk I also take into account how much money I need in the future. Common sense, no? Then in calculating this loss amount I do not use a correlation matrix but a causation matrix. Basically I use common sense to work out the relationship between asset classes. I analysis historical relationships only as a reference and then consider what is different in todays world. You see risk management should not be driven by quantitative individuals. It needs to be executed by individuals who are sensitive to the way humans behave. As much as I enjoy their company, and have a great deal of respect for them, quantitative individuals are generally not people persons. I think they are better to focus trying to make money especially in light of how ultra high frequency trading is increasing. Risk management is better left to individuals that question from a more qualitative fashion. This is exactly what I do and if global regulators came my way the financial world would be a safer place be. But not only safer but better equipped to make profit in the future. You see it is all about risk management. Risk management is about survival and recovery.