The five principles of correct riskometer use

27 April 2020

It is easy to criticise risk forecasting, but it’s rather pointless unless one can come up with proposals. Here are my five principles for the correct use of riskometers.

A few years ago, after I wrote a rather nihilistic piece called Risk and crises, I got a familiar criticism: “Jon. It is easy to criticise, but please offer an alternative.”

In response, I joined forces with a friend of mine, Robert Macrae, and we wrote two pieces called The appropriate use of risk models, Part I and Part II.

The starting point is that risk should only be defined in terms of the outcomes we wish to avoid, and how best to estimate risk critically depends on what we want.

Suppose Paul, Ann, and Mary each invest in Google stock. Their reasons for investing are quite different.

Paul trades on his own account, his intentions are speculative, and he is aiming to get out in one week with a big profit. Ann is a fund manager, investing on behalf of her bank, and her primary concern is beating her benchmark and avoiding large losses relative to her benchmark that would get her fired. Mary is investing for the long-term and worries about getting her pension 70 years into the future when she is 95 years old and relying on the financial industry for her financial well-being.

Even though each of the three made exactly the same investment and had access to the very same risk measurement technologies, their views on risk are very different.

  • Paul cares about day-to-day fluctuations over the next week;
  • Ann is worried about a substantial one-day loss sometime in the next six months;
  • Mary needs the Google stock price to continue to grow over the next 70 years and does not care about what happens to the stock in the meantime (and certainly not over the next week).

Their investment horizons are different, their objectives are different, and therefore what risk means to them is different. Each needs a different riskometer. Unlike temperature, where Celsius is the appropriate unit of measurement regardless of what it is used for, for risk, we need different concepts depending on the end-use.

Non-expert users find it difficult to comprehend that a risk measure depends on the circumstance, and by having a single riskometer, used for everybody, individual failure is covered by collective failure.

The five principles of the appropriate use of riskometers.

  1. Avoid at all costs one-size-fits-all type approaches when it comes to risk, like VaR, because how one should calculate risks depends on what one fears.
  2. Risk comes from the future, but we only know the past. All a riskometer can do is to project the past into the future and many conditions have to hold if the projection is to be accurate;
  3. The point of a riskometer is not there to predict bad outcomes. All it is supposed to do is to tell us that something bad may happen;
  4. Don’t probability shift. It is easy to estimate a model for short-term risk (like 95% daily VaR) and use that to get an estimate of a once in a century event. While easy enough to do, for the numbers to have meaning we need at least two strong assumptions — ergodicity and the correct parametric form — both of whom are violated in practice;
  5. Financial risk is endogenous, created by the interaction of the human beings that make up the financial system. Endogenous risk limits what any riskometer can do.

© All rights reserved, Jon Danielsson, 2020