Posts Tagged ‘volatility’

Government intervention leading to more risk for banks?

Tuesday, December 23rd, 2008

Back in How do you define risk?, we wrote,

In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is.

Also, as we wrote in Real economy suffers while financial markets stuff around with prices,

Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinder long-term planning.

Paradoxically, government interventions, for all their good intentions, are making the situation worse by introducing unintended consequences into the global financial system. For example, in the case for banks, Satyajit Das wrote in Fear & Loathing in Financial Products: Banks – The ?V?, ?U? or ?L?,

Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk taking and therefore earnings potential.

Everything else being equal, the increase in the amount of capital needed implies a reduced availability and amount of credit to the real economy. This in turn will have an effect on economic activity.

Tags: , , ,
Posted in Looking Forward, Market Observations | 2 Comments »

Is trend following trading risky?

Tuesday, January 30th, 2007

In a nutshell, Trend Following is a trading strategy that buys (or technically speaking, go ?long?) when prices are in an uptrend and short sell (or technically speaking, go ?short?) when prices are in a downtrend. Unlike other trading and investing strategies, trend following only look at one thing for its buy or sell decisions: price. Also, trend following does not try to anticipate price movements or foresee long-term fundamental outlook?it merely reacts to price behaviour.

Does trend following works? Michael Covel, in his book, Trend Following?How Great Traders Make Millions in Up or Down Markets made a thorough case for this trading strategy. We suggest you read his book if you are interested in the idea of trend following.

However, there are some in the finance industry who claim that trend following is very ?risky.? The underlying reason for such a claim is based in the fact that trend following exhibits very volatile returns. Is there any flaw behind such a claim?

First, how is volatility measured? Standard deviation is most often used for measuring volatility. The calculation of standard deviation requires the statistical mean as one of its input. Here lies the weakness for the claim that trend following is ?risky??the underlying assumption behind standard deviation is that prices follow a normal distribution As we said before in How the folks in the finance industry got the idea of ?risk? wrong!, this assumption is generally not true in practice. Price often moves in trends, and the incidence of extreme movements (e.g. 1987 stock market crash) shows that normal distribution is an invalid assumption. Therefore, according to the assumption of normal distribution, meltdowns like 1929 and 1987 are so rare that they occur once every billions of years (we are not sure of whether it is billions or millions, but you get the idea). Thus, if you believe in trend following, you cannot believe in the idea that volatility that is defined by standard deviation is ?risk.?

One more thing: since most of the financial industry uses the faulty normal distribution example as the basis for measuring ?risk,? we cannot help but feel that perhaps much of the financial risks in the world are being wrongly appraised. If that is the case, the next fat-tail event will indeed draw many nasty surprises.

Tags: , , , , ,
Posted in Investor Education, Trend Following | No Comments »

How do you define risk?

Monday, December 18th, 2006

The answer to this question depends on whether you are investing from the retail level or investing along with the legendary investors of excellence.

First, let?s look at the former case. In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is. This definition of risk arises from the fact that retail investors tend to perceive the safety of an investment in terms of how much of its value can be preserved within a given period of time. Since volatility does not engender the feeling of safety and confidence, it is to be avoided as risk wherever possible. The root motivation of this kind of perception is fear?the fear of losing it all. To assuage such fears, the financial services industry came up with ideas like portfolio management and asset allocation, in which their aim is to structure investment portfolios for the purpose of ‘controlling’ volatility, and thus risk, for a given return. However, in truth, no one can control volatility as much as the thermometer controls the weather. The best that can be done is to reduce the effects of volatility using past volatility behaviour as a guide.

Now, if you want to achieve results of excellence in your investment endeavour, you have to see risk differently. As contrarians, we define risk in terms of the soundness of the underlying economic and financial state. This implies that in order to understand the risk of an investment, we have to really understand the fundamental nature of the investment itself. Thus, if we invest according to our understanding of the economic and financial soundness of the investment, we should not let its short-term volatility perturb us.

To further illustrate today?s point, look at our views on gold. For this year, the gold price had been very volatile. Thus, compared with cash, the mainstream would see that gold is more ?risky? than cash. But in reality, if you understand the nature of today?s monetary system and economic reality, you will see that cash is in fact far more risky.

Hence, know your stuff.

Tags: , ,
Posted in Investor Education | No Comments »