The financial arena bubbles over with data of all sorts that can be used for
Common Brand of Risk
In the financial community, the term “risk” usually refers to the volatility of the price of an asset. We may refer this type of bugbear as chronic risk.
As an illustration, consider two funds named Alpha and Beta. We will assume that both pools are priced at $10 per share at the beginning of the year.
During the first month, the price of Alpha shares rises to $11. On the other hand, the asset crumbles to $9 over the second month. Then it reverses course and surges to $12 by the end of March.
By contrast, the price of Beta vaults to $13 during the first month. Then the fund crumbles to $8 over the next month, after which it bounces to $12 by the close of March.
The price of Beta has been more volatile over the entire period. For this reason, the security is said to be riskier than its counterpart Alpha.
On the other hand, both assets rose from $10 to $12 over the entire stretch spanning three months. As a result, the average return during this period was identical for the two funds.
In general, investors prefer higher gains coupled with lower risk. Unfortunately, though, the two goals are usually at odds: higher gains are apt to entail higher risk over the long haul.
Invisible Form of Risk
In addition to the fluctuation in price, however, there is a menace lurking in the background which the financial community rarely talks about in spite of its importance. All too often, an asset or even an entire fund breaks down and goes kaput. In that case, the investors in the vehicle end up losing their shirts in one fell swoop.
Since the notion of total ruin is a pariah in financial circles, hardly anyone likes to talk about it. In line with this state of affairs, there is no terminology that is in general use for this type of bogey.
Given its significance to the investor, however, the subject ought to be brought into the open and given its due. In the absence of a suitable term, we will refer to the prospect of death as terminal risk.
In line with the general aversion to discussing the subject, this type of threat is almost always ignored by the statistics of the forum. The omission is especially baleful in the case of a compilation such as the average performance of the “Top 100 Firms” in a particular area.
To bring up an example, suppose that a company or a fund named Gamma were to take on a massive amount of risk. As a result, the punter goes bankrupt during a short-lived swoon of the stock market around the middle of April.
In that case, the index of the Top 100 will ignore the ghastly fate of Gamma. According to the compilers of the yardstick, the defunct outfit is no longer part of the market.
In this setting, the monthly data for Gamma will end with its price in March, when everything was still hunky-dory. According to the statistics, nothing of significance has happened over the course of the month. In particular, the value of the yardstick at the end of April will be comparable to that of the previous month.
For the investors in Gamma, however, their portfolios tell a completely different story. Anyone who had a stake in the loser would have taken a drubbing in April.
To sum up, the statistics of the forum cover only the performance of the survivors. If you happened to own a significant stake in Gamma, then your portfolio took a sound beating. According to the benchmarks of the market, though, all is fine and dandy in the imaginary world pictured by the statistics.
The blind focus on survivors is especially problematic when the rate of mortality is high. As a case in point, the top tier of players in the hedge fund game has an attrition rate of roughly 50% over the course of five years.
Simply put, half of the best performers in this domain go out of business within half a decade. We will not even talk about the mediocre players in the arena, let alone the worst punters that die young and never make it into the big leagues at all.
Whatever their size, the losers are excluded from the ensemble and overlooked by the statistics as soon as they quit the field. For this reason, the “average performance” of the group that the yardstick purports to monitor does not reflect the average outcome for the entire population. Rather, the proxy measures only the average outturn of the players that happened to last the course thus far.
The financial arena teems with data of all sorts. In an effort to get a handle on a complex subject, investors routinely turn to statistical summaries of the forum.
Unfortunately, the data they draw on are often misleading. One of the glaring flaws lies in the fact that the risk of total failure does not show up at all in the usual statistics of the marketplace.
A case in point is the realm of hedge funds where half of the heavyweights go out of business within half a decade. The investors in the ill-fated pools lose their shirts en masse, but their misfortune is almost always ignored by the statistics of the domain.
As a rule, the benchmarks of the forum cover only the performance of the survivors. Even so, the yardsticks are usually trotted out as if they were objective measures of the players in the arena.
In reality, a benchmark of such stripe is objective only for an investor who happens to know beforehand the fate of every single asset during every interval of time in the future. In other words, the hypothetical gamester has the ability to figure out in advance whether each vehicle will survive or not over the next period – whether the interval is a month, a year, or whatever a particular benchmark happens to focus on.
In addition, the fictitious investor would also possess the wherewithal to close out accounts and transfer funds at will at the end of each period without paying a penalty of any sort. Otherwise there would be a constant stream of sizable costs due to the withdrawal of assets without prior notice from each pool that was about to collapse.
All that is quite a bit to ask for in a world populated by real people with genuine accounts.
If the investor happens to be a mere mortal, then they end up betting on the wrong horses from time to time. For the reason, the average investor is destined to underperform the “objective” benchmarks of the forum.
In the din and heat of the bazaar, even the statistics are patchy and slippery. Given this backdrop, the wily investor has to approach the data with a heap of salt in order to do a seemly job of