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Saturday 2 October 2010

Risk, But Not as Many Know It

A basic and undeniable fact: Risks exist in many forms.

One of the basic fallacies of modern portfolio theory is the belief that risk can be defined and measured by variability in the price of securities. However, this is only a partial measure of total risk.

I would define risk as the exposure to the possibility of loss.

A taxonomy of risk was outlined by former US Defence Secretary, Donald Rumsfeld, in a press conference in 2002: ‘Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.’

To some, this may seem an unlikely source for insights about market risk as well as general risks. We still do not have precise quantitative knowledge of the feedback between financial and real variables.

Known risks are those that are defined by current knowledge. They can be modelled, estimated and the parameters calibrated. Unknown risks are subject to statistical determination based upon what is already known, but the parameters cannot be calibrated. The unknowable risks cannot be known and cannot be modelled.

We humans seem to attach greater significance to specific events that have already occurred when we try to anticipate the future. That type of mental gymnastic is the reason that something that has never occurred gets a low probability when trying to predict or model risk.

Managing risks really means reducing the cost and likelihood of potential perils for a price. Our own approach incorporates behavioural, liquidity and non-linear dynamic factors.

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