Morgan Stanley IM: The Risk of Losing Money

Most ultimate end customers of the asset management industry would agree with a fairly simple definition of ‘risk.’ Be they savers, those drawing down savings in retirement, or in the case of defined benefit schemes, the shareholders or tax payers backing the sponsor, they would generally say that the fundamental risk is the risk of losing money and, in particular, losing significant amounts of money. 

Within the industry, life is rather more complex and has evolved to be out of line with the fairly simple proposition above. The understandable desire to measure investment performance, and mitigate career risk, means that the primary risk metric is often a relative one: ‘tracking error.’ Risk ends up defined as deviation from a benchmark, regardless of the absolute risk in the benchmark itself. Indeed, for those who concentrate on higher-quality stocks, it may well be the case that the higher the relative risk, or deviation from the benchmark, the lower the absolute risk of losing money

In fairness to the industry, the limits of the relative metrics are well known. We would argue that the main absolute measurement of risk, volatility, is actually even more problematic at the moment, as it may well be providing false comfort. Volatility is the measure of the dispersion of returns for a given security, portfolio or market index over a given period of time. The issue today is that the generally used ‘given period of time,’ be it three or five years, is now unrepresentative and dangerous. We are over nine years into an economic recovery, and associated bull market, and for the last few years have been in an absurdly low period of volatility, with the VIX Index lurking around 10 or even below. February seemed to be a wake-up call, but the index is now down at 12 again.

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