2012 ERM Symposium – Washington DC

The 2012 ERM Symposium will explore how risk professionals use ERM to meet their organizations’ challenges, especially those presented by the financial events of the past few years.

ERM Symposium sessions will address issues, applications, and insights across a broad spectrum of industries and foster cross-pollination and collaboration of ERM professionals without regard to industry, sector, or geography.

Now in its tenth year, this premier global conference on ERM will offer:

• five general sessions and more than 25 concurrent sessions featuring top risk management experts
• seminars on hot ERM issues
• networking opportunities to renew and expand your list of ERM contacts
• a track of sessions featuring academics presenting ERM research from leading universities
• exhibitors demonstrating their ERM services and knowledge.

Who should attend:

• Chief risk officers
• Chief financial officers
• Chief actuaries
• Risk professionals
• Equity analysts and other investment professionals
• Risk modeling experts
• Asset liability management practitioners
• Anyone interested in learning more about enterprise risk management
• Anyone interested in networking with colleagues about recent issues and how best to manage risk

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Presented by:

And in collaboration with:
         

Registration Now Open!

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Back from the Beach Risk

Has anyone ever figured out why going on holiday/vacation for a week requires an extra week of work both before and after?

Beach Risk

The risk that your risk manager will not come back from the beach.

Check back next week to see if Beach Risk has taken over the RISKVIEWS Blog.

TANSTAAFL

Hedge funds were the darlings of the past decade.  The 2 and 20 compensation lure of hedge funds is a major factor in the over compensation of bankers.  The argument was that if the banks did not match the hedge fund money, they would lose all their most talented people.
In 2011, 67% of hedge funds were below their high water marks according to a study by Credit Suisse.

What hedge funds promised was a Free Lunch.  But There’s No Such Thing As A Free Lunch!

The Economist summed it up perfectly in this letter to investors from the Zilch Capital Hedge Fund:

Dear investor,

In line with the rest of our industry we are making some changes to the language we use in our marketing and communications. We are writing this letter so we can explain these changes properly. Most importantly, Zilch Capital used to refer to itself as a “hedge fund” but 2008 made it embarrassingly clear we didn’t know how to hedge. At all. So like many others, we have embraced the title of “alternative asset manager”. It’s clunky but ambiguous enough to shield us from criticism next time around.

We know we used to promise “absolute returns” (ie, that you would make money regardless of market conditions) but this pledge has proved impossible to honour. Instead we’re going to give you “risk-adjusted” returns or, failing that, “relative” returns. In years like 2011, when we delivered much less than the S&P 500, you may find that we don’t talk about returns at all.

It is also time to move on from the concept of delivering “alpha”, the skill you’ve paid us such fat fees for. Upon reflection, we have decided that we’re actually much better at giving you “smart beta”. This term is already being touted at industry conferences and we hope shortly to be able to explain what it means. Like our peers we have also started talking a lot about how we are “multi-strategy” and “capital-structure agnostic”, and boasting about the benefits of our “unconstrained” investment approach. This is better than saying we don’t really understand what’s going on.

Some parts of the lexicon will not see style drift. We are still trying to keep alive “two and twenty”, the industry’s shorthand for 2% management fees and 20% performance fees. It is, we’re sure you’ll agree, important to keep up some traditions. Thank you for your continued partnership.

Zilch Capital LLC

There probably are a handful of money managers who are actually worth the 2 & 20.  But think about it, someone has to be on the other side of all of those trades where the hedge fund managers are winning.  Eventually, everyone who has money that is invested with a manager (or themselves) who loses every time either runs out of money or hires another manager, until more and more of the money is managed by people who are aware of all the ways that the hedge funds have changed the investment markets.

And the hedge fund tricks no longer work.

Three Ideas of Risk Management

In the book Streetlights and Shadows, Gary Klein describes three sorts of risk management.

• Prioritize and Reduce – the system used by safety and (insurance) risk managers.  In this view of risk management, there is a five step process to
  1. Identify Risks
  2. Assess and Prioritize Risks
  3. Develop plans to mitigate the highest priority risks
  4. implement plans
  5. Track effectiveness of mitigations and adapt plans as necessary

• Calculate and Decide – the system used by investors (and insurers) to develop multi scenario probability trees of potential outcomes and to select the options with the best risk reward relationship.
• Anticipate and Adapt – the system preferred by CEO’s.  For potential courses of action, the worst case scenario will be assessed.  If the worst case is within acceptable limits, then the action will be considered for its benefits.  If the worst case is outside of acceptable limits, then consideration is given to management to reduce or eliminate the adverse outcomes.  If those outcomes cannot be brought within acceptable limits then the option is rejected.

Most ERM System are set up to support the first two ideas of Risk Management.

But if it is true that most CEO’s favor the Anticipate and Adapt approach, a total mismatch between what the CEO is thinking and what the ERM system is doing emerges.

It would not be difficult to develop an ERM system that matches with the Anticipate and Adapt approach, but most risk managers are not even thinking of that possibility.

Under that system of risk management, the task would be to look at a pair of values for every major activity.  That pair would be the planned profit and the worst case loss.  During the planning stage, the Risk Manager would then be tasked to find ways to reduce the worst case losses of potential plans in a reliable manner.  Once plans are chosen, the Risk Manager would be responsible to make sure that any of the planned actions do not exceed the worst case losses.

Thinking of risk management in this manner allows us to understand the the worst possible outcome for a risk manager would not be a loss from one of the planned activities of the firm, it would be a loss that is significantly in excess of the maximum loss that was contemplated at the time of the plan.  The excessive loss would be a signal that the Risk area is not a reliable provider of risk information for planning, decision making or execution of plans or all three.

This is an interesting line of reasoning and may be a better explanation for the way that risk managers are treated within organizations and especially why risk managers are sometimes fired after losses.  They may be losing their jobs, not because there is a loss, but because they were unable to warn management of the potential size of the loss.  It could well be that management would have made different plans if they had known in advance the potential magnitude of losses from one of their choices.

Or at least, that is the story that they believe about themselves after the excessive loss.

This suggests that risk managers need to be particular with risk evaluations.  Klein also mentions that executives are usually not particularly impressed with evaluations of frequency.  They most often want to focus on severity.

So whatever is believed about frequency, the risk manager needs to be careful with the assessment of worst case losses.

Psychologists Tend to Overgeneralize

With the obvious failures of neo classical economics in the Global FInancial crisis, Behavioral Finance has been raised as the best explanation that we have for “how things work” and many people are trying to use BF as a basis for how to go forward.

BF is often held up as great work because its authors received a Nobel Prize.

But Behavioral Finance is psychology work that received a Nobel prize in Economics. I do not know, but I strongly suspect that few if any of the Nobel committee were experts on psychology.

But it does not take very much research to learn that there are quite a number of reasons to go slow in holding up BF as the next new thing to explain economic behavior.

Here are some things to think about when you look at Behavioral Finance:

• Behavioral finance starts out with the premise that Neo Classical economics is “correct” and that anytime that their study reveals behavior that is not consistent with neo classical economics that people are “biased” towards “wrong” behavior
• Many of the BF experiments were done with college students. Other researchers into the development of the brain find that the parts of the brain that support judgement are not fully mature until age 25 on the average
• All of the BF experiments are done totally “out of context” by definition. Most research into general human decision making shows that humans rely heavily on context for decision making. Some of the “biases” that BF have “found” may simply be the result of people inserting a context that is common to their experience into their answers instead of the purely academic contextless point of view that is being imposed to judge the answers.
• Psychologists strenuously try to avoid “the Practice Effect”. This is the effect of people learning from repeated tries on an experiment. However, “the Practice Effect” is the primary way that humans learn to get things correct. So it is possible that most of their conclusions only apply to the very first time that people make the sorts of decisions that are being tested. In fact, other psychologists have shown that the most consistently found bias, the overconfidence bias, can be completely overcome with experience.
• Many of the findings of BF are much less strongly in evidence with fairly small changes in wording of the questions asked. For example, in one study they found that more people would say that Mary was likely to be a feminist and a bank teller than just a bank teller. However, if they simply instead asked out of 100 women, how many would be bank tellers and how many would be bank tellers and feminists the bias completely disappeared.
• Some of the conclusions of BF that are questionable may be traced to flaws in neo classical economics. Neo classical economics assumes that there is exactly one correct view of both risk and expected reward. If you recognize that since both the risk and the reward are in the future and that it is impossible to in advance determine the exact correct answer for either risk or expected reward, the possibility of a variety of opinions is obvious. This line of reasoning permits may different “correct” answers.
• Real economic actors will say that academic discussions are one thing, but people making real statements of opinion are only credible when they are expressed with the commitment of funds. None of the BF experiments involve commitments of amounts of money that is real and significant to the subjects. All of their answers are therefore suspect.

The human element is very real in economic affairs. However, the simple experiments of BF are by no means the last word. They open us up to alternate lines of thinking than the even more oversimplified ideas of human behavior embedded into neo classical economics.

The final and most compelling reason for distrusting BF is the extremely high degree to incompetence that seems to be implied for the human race from the scores of biases that have been identified.  That just does not square with the simple observation that we no longer live in caves and hunt with sticks.  Somehow, along the way, humans made many, many decisions correctly.  If there were such strong biases towards wrong decisions, then it would be hard to imagine any such progress at all.