PI Partnership
Simon Hallett is a partner at Cambridge Associates
TIME TO RE-THINK RISK?
The impact of the Covid-19 pandemic upended markets. While broad indices have soared to new heights there remain huge divergencies between the winners and losers. It has been a stark reminder that financial markets do not follow neat rules and their characteristics are not stable. Why should they be, when they reflect the interactions of people framed by the ever shifting social and institution context of today? The pandemic is a timely reminder of how a truly long-term investor should be looking at risk and about how recently we may all have been looking in the wrong place. Back in the 1920s and 30s, John Maynard Keynes at Cambridge and Frank Knight at the University of Chicago were writing about the difference between statistical risk (think standard deviation around a mean) and uncertainty – that there are things we just cannot predict or model. Knight criticised what he called:
“The near pre-emption of economics by people who take a view which seems to me untenable, and in fact shallow, namely the transfer into the human sciences of the concepts and products of the sciences of nature.” …by which he meant the use of simplistic static models of objec- tives and preferences to reflect human behaviour and therefore the characteristics of asset classes. And Keynes wrote in 1937: “By “uncertain” knowledge…I do not mean merely to distinguish what is known for certain from what is only probable…The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the rate of interest 20 years hence, or the obsoles- cence of a new invention…About these matters, there is no scientific basis on which to form any calculable probability whatever.” But Keynes and Knight’s thinking was superseded in the post- war period by a belief in models and quantification that became the dominant narrative in economics and finance. In this neo- classical narrative the economy tends inexorably toward an opti- mal equilibrium point. In the investment world this led to the belief in optimal portfolios where risk is simply what you used in
20 Dec-Jan 2022 portfolio institutional roundtable: Build Back Better
mean-variance optimisation i.e., annualised standard deviation of returns – or volatility. It’s a framework that sees risk as some- thing akin to the probability of throwing two sixes with a fair dice; something controllable and calculable. More recently, critics have challenged this framework. In his influential book Black Swan, Nassim Taleb wrote about the importance of extreme events which the familiar bell-curve of the normal distribution says are exceptionally unlikely but which seem anything but. It is now almost a cliché to quote the unfor- tunate David Viniar, CFO of Goldman Sachs, who wrote of the global financial crisis: “We were seeing 25-standard-deviation events several times a week”. In his typically forthright style, Taleb writes: “The bell curve satisfies the reductionism of the deluded”, which is a fancy but concise way of saying that typical statistical analysis as practiced in the investment business doesn’t capture real world outcomes very well. But neither the financial crisis nor the Covid-19 pandemic were really black swan events in Taleb’s sense of being left-field events that could not have been predicted. Indeed, as Jeremy Farrar of the Wellcome Trust wrote in a Newsweek article: “A pandemic of this magnitude was not only predictable, it was predicted…We called for immediate, forceful and coordinated action. The response was non-existent.” Does that sound familiar? We could argue the same for climate change or antimicrobial resistance. And if you ask an invest- ment strategist at the beginning of any given year to list the 10 risks that might derail the outcome, global pandemic is almost always on there. But we find it hard to deal with these kinds of risks.
Bringing together many of the critiques of modern risk manage- ment in one fascinating book¹, John Kay and Mervyn King coin the phrase ‘radical uncertainty’ to describe situations “when we know something, but not enough to enable us to act with confi- dence. And that is a situation we all too frequently encounter”. Perhaps it is precisely this radical uncertainty that truly long- term investors should put at the heart of their approach to risk management. For those long-term investors whose wealth is only valuable as a source of continuous spending (a perpetual foundation or university endowment, for example) the concern must be about what will be the return generating potential of the portfolio not just from today but from 20 years or 30 years hence. Not just the portfolio value at a point in time but how it generates the returns that are needed to support spending. Here we perceive a convergence between sustainability broadly defined and plain old long-term investing. We want to be invested, in x years’ time, in a set of assets that are capable of generating at least as much purchasing power as our assets do today. To do so, they will have to be as relevant to society in year x and will have survived the twists and turns of crises, along with social, political and technological changes.
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