Ignorance isn’t bliss

Today’s highly quantitative risk management industry is the product of simultaneous advances in computing power and finance theory since the 1960s.

Exponential increases in computation speeds have allowed academics and practitioners to create a wide range of mathematical models, able to process vast amounts of historical data and create large numbers of projections of the future.

While undoubtedly useful when used appropriately, the resulting tools (now ubiquitous across the industry) have created an over-reliance on numerical estimates of risk.

The language of risk is dominated by the terms “volatility” and “value at risk” creating an unintended blind spot in relation to risks or trends that are inherently difficult to measure or quantify.

The following quote from Lord Kelvin – inscribed on the wall of the social sciences building at the University of Chicago – could quite easily be the slogan of today’s risk management industry:

“When you can measure what you are speaking about, and express it in numbers, you know something about it; but when you cannot express it in numbers, your knowledge is of a meagre and unsatisfactory kind.”

This very scientific perspective (Lord Kelvin was after all a physicist) encourages a belief in numerical measures as a mark of understanding, while disparaging insights that cannot be expressed in numbers.

However, as Andrew Lo and Mark Mueller pointed out in their paper “Warning: Physics Envy May Be Hazardous To Your Wealth!” some aspects of the world around us involve such a great degree of uncertainty, they simply cannot be quantified or captured in mathematical models.

As the author and philosopher G.K. Chesterton said:

“Life … looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”

We believe that an appreciation of the inherent “wildness” of economies and markets, and an acceptance that this complexity cannot be easily measured or captured in mathematical models, is an important first step towards arriving at a more robust outlook on risk.

This is not to suggest that quantitative tools should be abandoned altogether; rather that we should elevate a more qualitative perspective on risk to sit alongside the quantitative perspective that often dominates risk management discussions today.

‘Numbers’ failed to predict the GFC

It is important to acknowledge that we already place significant weight on qualitative views in many aspects of the investment decision-making process.

For example, stress tests and scenario analysis, manager research ratings, dynamic asset allocation views, operational due diligence assessments, environmental, social and governance views and ratings, and many other important investment activities are partially or largely qualitative in nature.

However, at a strategic level, many investors and financial institutions rely heavily on the numerical outputs of stochastic models, while qualitative considerations are treated as supplementary or of secondary importance.

We believe that a more robust approach to risk management should do two things to address this short-coming: first, it should raise the importance assigned to a qualitative perspective within the decision-making process, while correspondingly reducing our faith in the output from quantitative models; second, it should provide a broader perspective by expanding the types of risk considered as part of the strategy-setting process.

Adopting this broader perspective on risk is consistent with the direction of travel in the wider economic community since the financial crisis.

In recognition of the failures of modern economic thinking in predicting the financial crisis, complexity economics (a branch of economics that had until recently been largely ignored by mainstream economists) has been receiving an increasing degree of attention from both practitioners and policy-makers.

In short, complexity economics suggests a view of the global economy as an inter-dependent complex system that will experience periods of stability and – possibly extreme – instability. Needless to say, complexity economics views the world as is inherently difficult to model or forecast.

Developing a forward-looking risk management framework

The World Economic Forum produces an annual Global Risks Report that puts forward a survey-based, qualitative perspective on the major risks facing the world over the coming decade.

The report acknowledges the challenges of making such wide-ranging, long-term forecasts and uses a simplifying framework with five broad categories of risk:

Economic

Environmental

Technological

Societal

Geopolitical

Within each category, a number of important “global risks” are identified and their relative likelihood and impact are assessed.

We have adopted this framework as the starting point for creating a qualitative risk dashboard. This dashboard identifies a handful of potentially significant risks under each of the five categories.

Against each risk, we propose a number of possible mitigation actions, as well as approaches that might capture the upside opportunity arising from the market’s under-appreciation of a given trend.

The appropriate actions that follow will vary by investor, depending on time horizon, risk appetite and governance budget. However, in broad terms, we believe that three categories of action warrant discussion:

At the board level, investors should be clear on the time horizon and categories of risk that matter most to them. A clear set of beliefs is a pre-requisite for effective decision-making.

At the strategy level, investors might identify specific areas of risk that could present a material threat to their objectives and consider actions to mitigate or manage those risk exposures.

At the portfolio level, investors should seek to ensure that the time horizon of their underlying managers is consistent with their own time horizon. In addition, strategies with a focus on delivering sustainable long-term returns are likely to adopt a broader perspective on risk, by considering factors such as environmental, social and governance and other risks, as a natural part of their portfolio construction process.

In an increasingly complex and inter-connected world, we believe that a broader perspective on risk is essential in helping investors navigate an uncertain future.