Presentation Transcript

1. Risk in Financial MarketsThe Prime Directive versus Sharks

   21 June 2011 Rodney N. Sullivan, CFA Head, Publications and Editor, Financial Analysts Journal
2. Risk in Financial Markets The Prime Directive versus Sharks “Forecasting is difficult, especially when it’s about the future.” — Nobel Prize-winning physicist Niels Bohr (1885-1962). Popularized by Yogi Berra.
3. Fat-Tailed Events How rare are black swans, really? “Once-in-a-century crisis” — Alan Greenspan Q: What is the probability of a 50% drawdown in stocks during a 100-year period? Assume: 7.5% annual return 18% standard deviation A: 90% (50% decline almost certain!) Source: Zhou, Guofu, and Yingzi Zhu. 2010. “Is the Recent Financial Crisis Really a ‘Once-in-a-Century’ Event?” Financial Analysts Journal, vol. 66, no. 1(January/February). Image source: sxc.hu
4. Black Turkeys Source: Siegel, Laurence B. 2010. “Black Swan or Black Turkey?” Financial Analysts Journal , vol. 66, no. 4 (July/August).
5. Market Risk A Better Way Forward Financial economists have done poor job at understanding the connection between markets and the macro economy Markets are social environments Governments seek to socialize downside risks We must seek better understanding Better models: systemic risks and downside events Image source: sxc.hu
6. Economy and Markets Real Growth S&P 500 and U.S. GDP Market returns mirror overall economy… Source: Sullivan, R. 2008. “Taming Global Village Risk.” Journal of Portfolio Management (Summer)Data source: U.S. BEA, Robert Shiller, author analysis.
7. Economy vs. Markets … but the economy has become more stable; capital markets less stable Real Annual Change S&P 500 and U.S. GDP Source: U.S. Bureau of Economic Analysis, Robert Shiller, author analysis. (http://www.econ.yale.edu/~shiller/data.htm)
8. Great Moderation Factors driving calming economy Economic Sector Diversification Geographic Diversification Government Safety Net Programs Monetary and Fiscal Policy
9. Physics Envy The “Prime Directive” “Explain asset prices by rational models. Only if all attempts fail, resort to irrational investor behavior.” — Mark Rubinstein Source: Rubinstein, Mark. 2001. “Rational Markets: Yes or No? The Affirmative Case.” Financial Analysts Journal (May/June) Image source: blastr.com
10. The Sharks “Neoclassical finance is a theory of sharks and not a theory of rational homo economicus.” — Stephen Ross2001, “Neoclassical and Alternative Finance” “I predict in the not too distant future, the term behavioral finance will be correctly viewed as a redundant phrase. What other kind of finance is there?” — Richard Thaler 1999, “The End of Behavioral Finance,” FAJ Image source: sxc.hu
11. People Are Behavioral, not Perfectly Rational Heuristics can lead to errors in judgment Common Behavioral Errors Confirmation bias Overconfidence bias Over-optimism Short-termism Hindsight bias Recent memory bias Group think (herding) Prospect Theory: Loss aversion; disposition effect Mental accounting Narrow framing Anchoring Image source: sxc.hu
12. Economics as a Social Science Overconfidence bias Overconfidence encourages excess risk taking. 192 222 Source: Newport, John Paul. 2008. “A Tee Too Far.” Wall Street Journal (16–17 February):W7.
13. Economics as a Social Science Group think (Herding effect) Fat Tails and Nonlinearity: Millennium Bridge Wobble Investors get lulled into behavioral traps: False sense of confidence, hindsight bias, group think, etc. Leads to breakdown in diversity. Source: Strogatz, S., D.M. Abrams, A. McRobbie, B. Echkardt, and E. Ott. “Crowd Synchrony on the Millenium Bridge,” Nature, vol. 483, no. 3 (November 2005):224–226.
14. Bubble Cocktail Bubble ingredients persist through time Collective Delusion Market Innovation Speculative Leverage Source: Sullivan, R. 2009. “Taming Global Village Risk II: Understanding and Mitigating Bubbles.” Journal of Portfolio Management (Summer) Image source: etftrends.com
15. Bubbles in History Source: Sullivan, R. 2009. “Taming Global Village Risk II: Understanding and Mitigating Bubbles.” Journal of Portfolio Management (Summer)
16. Bubble Ingredients Here to Stay A need for evolutionary tools Complex interconnectedness of markets. Explaining uncertainty (not predicting). Nonlinear dynamics. “[The economy is] a chaos that is not under analytical control.” — Joseph Schumpeter
17. Fat Tails and Nonlinearity: Stocks Risk Management 2.0 Source: Morningstar EnCorr, author analysis
18. Fat Tails and Nonlinearity: Stocks Risk Management 2.0 Source: Morningstar EnCorr, author analysis
19. Fat Tails and Nonlinearity: Stocks Source: Morningstar EnCorr, author analysis
20. Fat Tails: Beyond Stocks Skewness and Kurtosis:14 Asset Classes, 1990-2010 Bonds Source: Xiong, J., and T. Idzorek. 2011. “The Impact of Skewness and Fat Tails on the Asset Allocation Decision.” Financial Analysts Journal, forthcoming March/Aprill.
21. Dynamic Tail Risk GEV Return Densities: (’96-Aug ’08) and (’96-Dec ’08) Source: Sullivan, R., S. Peterson, and D. Waltenbaugh. 2010. “Measuring Global Systemic Risk: What Are Markets Saying about Risk?” Journal of Portfolio Management (Fall).
22. Measuring Financial Turbulence Imminent Risk: Five Asset Classes λ(t, x, β ) = exp(β0 + β1VIX+ β2DEF + β3TED) Source: Sullivan, R., S. Peterson, and D. Waltenbaugh. 2010. “Measuring Global Systemic Risk: What Are Markets Saying about Risk?” Journal of Portfolio Management (Fall).
23. Fat Tails and Nonlinearity: Hedge Fund Wobble Source: Morningstar EnCorr, author analysis
24. Fat Tails and Nonlinearity: Equity Market Wobble Source: R Sullivan and J Xiong , 2011 Working paper
25. Fat Tails and Nonlinearity: Credit Market Wobble
26. Conclusions Seek evidence contrary to your point of view. Falsification is better than verification. Be mindful of the herding effect and the resulting diversity breakdown. Difficult because diversity breakdowns happen suddenly. Look for nonlinear reactions in our complex, adaptive financial market system. Small perturbations lead to outsized and unexpected outcomes. Economics is a high-complexity science. Involves the study of complex adaptive systems; dynamic and perpetually on the edge of chaos: Not an ordered regime always in equilibrium and mostly stable. Simplify and clarify. We must not abrogate our responsibility to a strong capital market foundation. “A risk-less society is unattainable and infinitely expensive.” — Ned Goldwater (childhood friend of Peter Bernstein)
27. We’re All Keynesians Now Fiat Currency Wobble Source: Sullivan, R. 2009. “Where Will Fiscal Stimulus Lead G7 Economies?” CFA Magazine (September/October).
28. We’re All Keynesians Now Can’t spend our way out of debt Source: Sullivan, R. 2009. “Where Will Fiscal Stimulus Lead G7 Economies?” CFA Magazine (September/October). Data source: IMF, author analysis.