Myth of diversification as safety?Part 2: nature of risk

March 28th, 2007

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Continuing from our previous article, Myth of diversification as safety?Part 1: definition of risk, we will then ask the next question: what is the nature of risk?

First, we have to define risk properly. Warrant Buffet?s 2006 Chairman?s Letter expressed it well (emphasis ours):

Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.

Therefore, risk is something that you cannot simplistically reduce to a precise number obtained from a mathematical model. As we said before in How do you define risk?, risk has to be defined in terms of the ?soundness of the underlying economic and financial state.?

Therefore, in light of this, we see that risk assessment is more of an art than a science. This does not mean that all mathematical modelling of risks should be thrown away?they have its use when utilised appropriately. To understand why, we have to recognise that all models employ underlying assumptions for its construction. We have to determine whether the assumptions are valid or accurate in a case-by-case basis. For example, almost all of the option-pricing models assume that prices follow a Normal distribution. Is this a valid assumption? Can we apply it to our specific situation? These are the critical questions we have to ask ourselves whenever we use mathematical models.

Thus, do not leave all the risk assessments to the computer! Do so at your own peril!