BGN Entrepreneur

According to the responses to FTfm in its informal survey of the industry, from now on, the asset management industry is going to have to take more account of risk. “The most important lesson is about managing risk”, “the crisis has highlighted the importance of managing risk in asset management”, “regardless of its nature, risk has to go back to the heart of the investment approach of a solid investment manager”, these are typical comments from the chief executive, chief investment officers and consultants who pondered the lessons of the past decade and forecast the challenges of the next for us.
In some ways, this is a no-brainer. Many portfolio managers failed to predict the massive increase in correlation as things went wrong and lost vast amounts of money for their clients. These clients rightly felt aggrieved, having been told the diversification of their portfolios would protect them from losses.
Clever people have been turning their minds to how to model financial markets in bad times—RiskMetrics, MSCI Barra dn Goldman Sachs all look to a regime-shift model. In this, you use one model for markets when all is going well, or at least as well as can be expected, and another in dark days when it seems all hell may break loose at any moment. This latter is concocted by plucking those days or periods from the past the analyst thinks were turbulent and building a model based on those samples rather than the entirety of historical data available.
But simply to say the asset management industry needs to focus more on risk is an empty truism if there is no attempt to think about how risk has featured in asset management and why that was inadequate. It is even possible that building more and better mathematical models of risk will not make things better for the asset management industry.
This is because mathematical models assume the outcomes will be received by rational investors. These mythical beings are not uniform, they can be risk averse or risk seeking, but they value what they may gain at the same rate as what they may lose, and their level of risk aversion is unaffected by how other people are doing.
Unfortunately for the number-crunchers, this is not the case. End=investors are ultimately human, and it is becoming clear that humans are irretrievable subject to impulses and vagaries that do not fit the neat description of rationality.
The growing field of behavioral finance is attempting to explore the bounds of rationality in decision-making, working out whether our irrationality is systematic and whether a better understanding of it can improve investments. Even more important for asset managers, it looks at how individuals value outcomes, not symmetrically. Losing something hurts more than gaining something of the notional equivalent value pleases us.
At the moment, behavioral finance as a discipline is still very largely based on the experiments done in controlled conditions, usually on college students. Critics like to point out that this is a far cry from financial markets, where billions of decisions are made, mostly by professionals, in distinctly uncontrolled conditions. But since the pure mathematical approach appears to have let down its proponents badly, whether because of a fundamental wrongness or because it was incorrectly applied, perhaps the behavioralists should allowed more respect.

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