Risk Management – Controlling what you have not thought of

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“Risk is what’s left over when you think you’ve thought of everything.” – Carl Richards from “Risk Management” by Morgan Housel October 4, 2018


“Real risk is in the error term, what is unexplained after we factorize asset returns.”


“If I can measure it, I can hedge it.” 

 

If you know your market beta exposure, you have good choices. You can either accept the risk or hedge it. If you know your market beta exposure and this beta explains a significant portion of the variation in returns you can have comfort that the amount of surprise will be limited. 

 

If you have an asset that has some market risk but a large portion that is unexplained, the risks you face are different. You still can either leave the market risk exposed or hedged, but the majority of the risk cannot be explained. Hence, it cannot be truly hedged. You can conduct further analysis to measure the risks from other factors but you may still be left with a high percentage unexplained. You may have thought of everything with respect to your risks, but there is a lot leftover.  


Your choice now is either to diversify away this idiosyncratic risk or do nothing. Diversification is a good strategy but not satisfying because you may hold more assets under the expectation that these unique risks will offset the unknown. It is a strategy based on failure to measure and a failure to explain. Your focus has to be trying to reduce the amount of risks that are not obvious which has been a problem faced by almost any decision-maker.  

 

“The secret of all victory lies in the organization of the non-obvious” 

– Marcus Aurelius