It is easy to criticise risk forecasting, but it’s rather pointless unless one can come up with proposals. Here are my five principles for the correct use of riskometers.
A few years ago, after I wrote a rather nihilistic piece called Risk and crises, I got a familiar criticism: “Jon. It is easy to criticise, but please offer an alternative.”
The starting point is that risk should only be defined in terms of the outcomes we wish to avoid, and how best to estimate risk critically depends on what we want.
Suppose Paul, Ann, and Mary each invest in Google stock. Their reasons for investing are quite different.
Paul trades on his own account, his intentions are speculative, and he is aiming to get out in one week with a big profit. Ann is a fund manager, investing on behalf of her bank, and her primary concern is beating her benchmark and avoiding large losses relative to her benchmark that would get her fired. Mary is investing for the long-term and worries about getting her pension 70 years into the future when she is 95 years old and relying on the financial industry for her financial well-being.
Even though each of the three made exactly the same investment and had access to the very same risk measurement technologies, their views on risk are very different.
Their investment horizons are different, their objectives are different, and therefore what risk means to them is different. Each needs a different riskometer. Unlike temperature, where Celsius is the appropriate unit of measurement regardless of what it is used for, for risk, we need different concepts depending on the end-use.
Non-expert users find it difficult to comprehend that a risk measure depends on the circumstance, and by having a single riskometer, used for everybody, individual failure is covered by collective failure.
© All rights reserved, Jon Danielsson, 2020