Risk Management: Foundations for a Changing Financial World

CHAPTER 16

RISKINESS IN RISK MEASUREMENT^p

Roland Lochoff

People are biased toward exact solutions; thus, they seek exact tools. But investment tools and techniques are not exact, and if they are used without sensitivity to their inherent uncertainties, costly errors can result. This understanding is particularly significant for the quantitative methods used to calibrate static and dynamic risk.

In his presentation in this proceedings, Lee Thomas noted that modern portfolio theory (MPT) is still called modern portfolio theory. ¹ How many 50-year-old ideas are still called “modern”? Let me suggest that one of the reasons the label modern persists is the empirical nature of MPT. Some evidence supports this theory, but other evidence contradicts it. This is not to suggest that the theory is shaky. Rather, I would like to say that the evidence is shaky. The uncertainties inherent in social science result in the need for continuous exploration, for examining the underlying assumptions for fit, and for a skeptical nature to question supposedly universal truths. This description sounds like the skills needed for portfolio management. In this presentation, I will endeavor to examine the firmness of the ground on which investment management stands. I hope that the insights derived from my simple examples will create a more effective means for interpreting and using the quantitative tools that underlie many of today’s portfolios.

This presentation will focus on how tools used without sensitivity ...