| Philippe Jorion is a Professor of Finance at the University of California at Irvine. His recent work addresses the issue of forecasting risk and return in global financial markets, as well as managing exchange risk with derivative instruments. Books Value at Risk Fieldbook , McGraw-Hill, 2000 Value at Risk, Irwin , 2000 (2nd ed.) Big Bets Gone Bad , Harcourt Brace, 1995 Value at Risk -
Balance returns against risk. If you want no risk, invest in cash. You sure cannot get greater returns without assuming some risk. Your goal should be to get the just reward for the risks you elect to take. But you need to measure your risks. -
Use Value at Risk ( VAR ) for an intuitive sense of risk. VAR is a first-order measure of downside risk. It is the maximum loss over a target horizon that will not be exceeded at some confidence level. Say you have $1 million invested in a diversified stock portfolio. You would then say: "Over the next year, the VAR at the 95% confidence level is approximately $330,000." You would expect this loss not to be exceeded in 95% of cases, or 19 years out of 20. But in one year out of 20, there will be a larger loss. If you are uncomfortable with this risk profile, you should alter the asset allocation. But at least this will be an informed decision. -
Risk should be measured in a portfolio context. What looks like a volatile investment, say in an emerging market, may have little effect on the total portfolio risk. Actually, if foreign equities move in opposite cycles to domestic stocks, portfolio risk is reduced. Limiting the amount invested in more speculative assets can also control risk. Portfolio risk is best measured with VAR. -
Beware of chasing winners. Picking losers among mutual funds is a bad idea, but picking winners can be dangerous too. Winning portfolios may be heavily exposed to the same risk factor, say the high-tech industry. If so, loading the portfolio with winners will create undue risk concentration. A downturn in this industry will hurt badly . -
Risk is a double-edged sword. Beware of traders that enjoy sizzling returns. Risk is the dispersion in unexpected outcomes , and not only the occurrences of losses. Countless investors have missed this point, as they failed to realize that the performance of traders, such as Nick Leeson or Robert Citron, really reflected greater risks. Extraordinary performance, both good and bad, should raise red flags. Ask questions, if only to imitate them. -
There is no such thing as 10% or more excess return with no risk. Anybody making such a statement either has not measured risk or did not measure it well. Robert Citron maintained that his fund was "safe". He managed to lose $1.6 billion out of $7.5 billion invested. He did not measure his risk. The partners at LTCM maintained that the fund had a daily volatility of $45 million only. They managed to lose $4.4 billion out of $4.7 billion. The real risks were misunderstood. -
Watch for large short positions in options. These created most financial blowups. Short options positions collect regular premiums but take a large hit once in a while. Victor Niederhoffer was a legend in the hedge fund business, returning an average of 32% annually from 1982 to 1997. In 1997, he sold naked out-of-the-money puts on the S&P and was wiped out as the market dived. LTCM's positions amounted to a huge short option position, a bet on volatility and liquidity risk. Similarly, selling earthquake insurance is profitable until the big one hits. www.gsm.uci.edu  |
