Traditional risk management techniques have failed the asset management industry in recent years as portfolios have been unable to deliver sustainable returns throughout the economic cycle.
The world, and consequently the factors affecting investment portfolios, has shown itself to be more complex and therefore less predictable than has been assumed to date, and particularly with regard to the impact of human behavior on investment returns.
The requirement for contingency planning for risks that we cannot know about ex ante requires a sea change in the industry’s approach to risk management.
Effective liquidity planning and protection of portfolios against clear secular risks, such as inflation, must form a core part of a robust risk management approach.
Risk management has taken centre stage in many commercial organizations in recent years, but it is in the financial services industry that it has assumed the greatest prominence, particularly since the subprime crisis and the ensuing credit crunch of the late “noughties.” Major banks and asset management firms now boast a chief risk officer (CRO) sitting alongside the chief financial officer (CFO) and other executives on the main board. While this innovation could be viewed as rather shutting the stable door after the horse has bolted, it nonetheless demonstrates a renewed commitment to risk management, which has traditionally been viewed as a synonym for “business prevention.” This previous sentiment was clearly demonstrated in an infamous incident involving the then CEO of the Halifax Bank of Scotland Group (HBOS)—who was also the deputy chairman of the United Kingdom’s Financial Services Authority (FSA) before he was forced to resign—who fired the group’s risk manager at the height of the subprime boom in 2005 for challenging the bank’s cavalier approach to risk management.1,2
The focus on overhauling risk management in financial services gained considerable impetus from the publication of official critical reviews, such as the Turner Review3 by the FSA, which, although primarily concentrating on the banking sector, nonetheless calls into question the fundamental tenets on which risk analysis in the asset management industry have been traditionally based. While those of us who have lived through a series of greed/fear cycles in financial markets over the last 25 years or so may be forgiven for cynically anticipating that any new prudent risk management measures will quickly be discarded if and when markets begin to rally, it is likely that the subprime crisis and its aftermath will result in a lasting philosophical change in the risk management paradigms employed by asset managers.
The statistically convenient and mathematically elegant models previously used in risk modeling must give way to more heuristic and empirically effective approaches to analysis that reflect the realities of the world of investment and are better able to allow for the idiosyncratic and, at least partially, stochastic behavior of financial markets. Economics is a social, not a pure, science, unlike pure mathematics or physics, and consequently cannot be modeled in the same way. The effect of collective human behavior that influences all economic indicators is exacerbated in financial markets, which are more strongly and immediately influenced by the emotions of greed and fear. Any analysis of risk that does not encompass the impact of human behavior in financial markets (or “behavioral finance” as it is generally called) is probably dangerously incomplete.
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