When Herb Chain (of Deloitte), Matt Forstenhausler (of E&Y), and I used to regularly teach AIMR-PPS(R) and then GIPS(R) courses (first for AIMR, then for the CFA Institute), one thing we could be sure of: Herb would reference former U.S. Supreme Court Justice’s famous line about not having a definition for pornography, but knowing what it was when he saw it. Over the years I, like Herb, have used this line metaphorically, as it fits a variety of situations.
Well, when it comes to risk measurement his line doesn’t fit, as their are several definitions available. Leslie Rahl (of Capital Market Risk Advisers) has become somewhat famous for her long list of risks, which she further qualifies as being incomplete. There is no commonly used definition for risk, and perhaps this is how it should be. Risk is usually defined in four ways:
- Possibility of a loss
- Possibility of not meeting the client’s objective
Volatility probably has the most number of measures, with standard deviation being the most common, as well as the most frequently used measure overall. One cannot assume that because most firms use standard deviation that they therefore interpret risk to mean volatility; it’s likely that they look at risk in a different way, but use standard deviation to try to assess risk in line with the other definition (which can be a challenge). Other measures include beta and tracking error.
The possibility of a loss and possibility of not meeting the objective can be measured using the same formula: Sortino ratio. We just adjust the absolute return in our equation, from zero (for a loss) to our goal, or minimal acceptable return (or, if you prefer, minimum funding ratio or liability related benchmark).
Uncertainty is difficult to measure. Scenario analysis can be used here, where we look at different possible future events to see how our portfolio would behave. Value at Risk and Liquidity Risk might also work, too.
Regardless of your definition, we see risk as something that needs to be “ganged up on.” That is, approached from multiple angles to get a sense of what is really there. The old television game show, Concentration, might be a good metaphor for risk. We want to get a good look at what risk is, but must take several views to really understand it. But unlike the game show, it never fully reveals itself.