Risk Management is an Oxymoron

June 24, 2010 at 2:27 pm Leave a comment

One of the faults of the investment industry is that reason and hubris too often trump common sense. Risk management is a good example of what I mean. Every investment firm trumpets its ability to manage risk as one of its greatest selling points to both its present clients and to future clients whom it tries to recruit through its ability to manage risk. Yet the term risk management is really an oxymoron – the words risk and management contradict each other and so, in the end, make no sense. Risk means the chance of a loss in an investment while management infers such things as structures, policies, use of predictive models, personal experience of managers to know or to sense what is happening in the markets that will control the exposure of any investor to a loss in their investments and thereby minimize the potential for that loss.

First of all, the market is not rational. Indeed, no one really knows how the modern market really works. Note all the different predictive tools in use by analysts to try and to figure out what the market will do and all of these tools, in the end, fail. So many factors outside the control of rational thought influence what the market does – wars, greed, fear, environmental catastrophes (natural ones like earthquakes or hurricanes and human created ones like BP’s oil spill in the Gulf of Mexico), terrorism, short term political and economic thinking that has long term harmful consequences (i.e., the ongoing fall out from those toxic sub prime mortgage investment vehicles) and the list goes on and on. The point here is that most of the consequences falling out from the above mentioned risks are outside of any person or group of persons in a financial institution to control or to manage. Indeed, what can best be said is that risks and their consequences are not managed (they can’t be!) they are reacted to after the fact in an effort to salvage what can be salvaged from the destructive consequences of that risk which is no longer a risk but now a catastrophe.

The investment industry couches risk management within an investment strategy known as a balanced investment strategy which is a method of portfolio allocation designed to provide both income and capital appreciation while avoiding excessive risk. Such a strategy has the ability to ‘win’, to make a profit, more often than it ‘loses’. However, the dynamic of the market is such that it only takes one catastrophe to wipe out the gains (and the original principle) of many wins. A better term for risk management, though admittedly not as macho and in-charge sounding, is reactive risk response – how quickly and effectively is the investment professional and investment firm able to minimize the negative consequences of any catastrophe.

What has all of this to do with ethics? It is about honesty to clients. Call a spade a spade and don’t dress up what is essentially unmanageable with terms that imply the unmanageable can be managed. Transparency is called for here. Investing is a crap shoot in which the dice are often loaded and the crap table moves or completely flips over unpredictably.

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