Lessons from a Bull Market that Never Happened

This is the 10 year anniversary of the publication of the book Dow 36000. Right now, the Dow is actually below the level of the Dow of 10 years ago.

Bret Arends writes about the lessons that two market crashes might have brought to investors in the Wall Street Journal.

Here are some thoughts on his seven lessons from the point of view of a risk manager, rather than an investor.

1.  Don’t forget dividends

Dividends are the hard cash part of stock returns.  As a risk managers, we need to keep in mind the difference between the real hard cash elements of the risks that we evaluate as opposed to the models and market values.

2.  Watch Out for Inflation

Inflation creates two major concerns for a risk manager.  The first is of course the concern of whether you have taken rising costs into account properly in the evaluation of multi period risks.  The second goes the other direction.  Because of inflation, the over conservative risk manager is a danger to his organization because she might just keep the business from growing enough to keep up with inflation.  A constant cycle of cost cutting to keep costs in line is not a viable long term strategy for a company.

3.  Don’t Overestimate Long Term Stock Returns.

The risk manager needs to keep reminding management of things like this.  Once someone pointed out that long term stock market average returns, even if you got them right, were misleading anyway because some part of that long run average was built up in a period when PE grew to historical highs.  So te starting point matters.  The same logic will apply to other financial series.  The starting point matters.

4.  Volatility Matters

You have to live through the short term to get to the long term.  The fact that your firm can afford the volatility does not mean that the board will keep the same management through what seems to them to be excessive volatility.  It is only the regulators who are focused on ruin only.  Watch your volatility.  Have conversations with your board about volatility.  Understand their volatility tolerance, both on a relative and on an absolute basis.

5.  Price Matters.

Risk managers need to focus both on controlling losses and on optimizing returns on risk.  So the prices of your risks does matter.  Some would argue that you only need to get a better return for risk that the market you are in (i.e. that risk reward is purely relative to the market), but just like volatility, the risk manager needs to understand the degree to which her board cares about absolute return and how much they care about relative return.

6.  Don’t Hurry.

Even more than investing, risk management needs careful thought.  That is why risk management is so very unlikely in a bank trading area where there is tremendous pressure to keep up with the frenetic pace of the trading desks.  If you are a risk manager in any other situation, you need to learn to insist on being given enough time to get your analysis correct.  If you are that risk manager on the trading desk, that is when you must have that authority to unwind things that turn out, when you take the time, after the fact, to be much worse than advertized by the trader.

7.  Don’t Forget Your Lifeboats.

The first thing that a risk manager needs to know is the exact situations where his firm will need a life boat.  Then he has to make sure that there are enough lifeboats and finally she must carefully watch for distant signs that the storm that will swamp the ship is on the horizon.  A firm that wants to survive for the long term will give its risk manager some leeway for false alarms, so that they are sure to be ready for the real thing.

Explore posts in the same categories: Action, Investment, Risk, Risk Learning, Risk Management


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