On the morning of August 7, 1974, Philippe Petit stepped off the side of the world’s tallest building. With more than 1,362 feet (415m) beneath him, he spent 45 minutes walking between New York’s Twin Towers, defying wind gusts, cable oscillations and the orders of the police perched on either end.
What became known as the “artistic crime of the century” can help us understand the different notions of risk in financial markets, and identify what truly matters.
There is no single right way to think about risk, so we should look to the concept that is most appropriate for a specific purpose. In Man on Wire, the acclaimed documentary about the high-wire crossing, Petit explains, “A cable between two buildings of a long length ... it sways, it goes up and down, and there is almost an invisible move which is a torsion on itself.” The oscillations of the cable can make the journey fraught with danger and, analogously, on financial markets relative volatilities between assets can act as a proxy for their relative risk. In the short term, for instance, equities are more liable than bonds to suffer from a significant sudden loss because they are more volatile.
But volatility is a poor indicator of the absolute risk of any asset in the longer term. As our Managing Director of Aberdeen Asia Hugh Young describes, “While this gauge gives an idea of the variability of the price of an asset, it won’t shed any light on the likelihood of permanent loss of capital.”
The type of risk he describes, permanent loss, cannot be found in the oscillations of the cable; it is better informed by the distance between the cable and the ground. The most important risk that Petit faced, as he walked through the sky, was not the risk of falling per se but the risk that a fall would lead to his premature and permanent end. The higher he was off the ground, the greater that risk.
Similarly, the risk of permanent loss is greatest when assets are purchased at too high a price. Expensive assets have low subsequent returns, as long-term valuation ratios exhibit mean reversion. Sensible valuation metrics, while not informative of performance in the short term, are useful guides to risk in the longer term. In equities, cyclically adjusted price-to-earnings ratios offer a useful metric of valuation, but lesser-appreciated credit spreads are a useful ratio too. A spread is nothing but a yield over a riskless asset divided by a price; conceptually, it is the inverse of a price-to-earnings (P/E) ratio.
The risk of permanent loss is greatest when assets are purchased at too high a price.
Yet how can we make sense of the idea that a low-volatility asset class may at times present high risk? And why do investors buy expensive assets? At times, the market underappreciates the range of things that may happen in the future; assets can become expensive when risks to the downside are insufficiently accounted for. Understanding this requires a new idea of risk: risk as getting things wrong, or as something unexpected happening. “Human decisions affecting the future, whether personal or political or economic, cannot depend on strict mathematical expectations, since the basis for making such calculations does not exist,” economist John Maynard Keynes remarked in The General Theory of Employment, Interest and Money. So investors must also account for the unknown unknowns without being able to predict them.
Market consensus is a myth
Risks in financial markets have a particular form of existence. Whereas in everyday life, a risk is a mere possibility, in markets it is an attribute of the present reality. Foreseen risks form part of the market price, and therefore have an existence whether or not they materialize. Risk as permanent loss becomes the possibility that the risk pricing changes radically, revealing that it had been underestimated.
Market prices don’t represent a consensus so much as an unstable balancing point between the competing influences of investors’ conflicting views. The notion of a market consensus is based on a profound misunderstanding of the way markets operate. It is not the case that all participants sit around a table, iron out their differences, and settle on one view of the world.
Prices today lock in the various competing visions of the future
In managing risk, we need to approach the market with a spectrum of scenarios for the future – a spectrum of risks; for it is this full spectrum, and not any one particular outcome, that will determine the future price of an asset.
We must manage the probabilities and guard against the uncertainties. In fixed income, we do this this by comparing the asset price determined by our own risk spectrum against the pricing of the market, the magnitude of the moves foreseen in different scenarios informed by our outlook as well as current valuations. In this way, we can benefit from periods when the valuations move away from fundamentals, because risks become under- or over- appreciated by the market.
Risk in finance needn’t be nebulous. We can take a common sense approach, and resist the mathematical obscurantism that leads others astray. Philippe Petit knew his feat would impress the world, because of the tremendous risk he was taking by walking on a cable so far from solid ground. Investors, conversely, are not there to impress. It is in managing risk by responding to what matters most that we fulfill our responsibility to our clients.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).