Every closet economist knows that risk is the most difficult concept to put a number to.  Most modelling relies on various (historic or predicted) estimates of volatility, but volatility is a very funny thing.  We often forget, especially during economic and stock market slumps, that we adore upside volatility even though we may loathe downside volatility.

Shortly after the Crash of October ’87 (yes, I’m dating myself) I recall an insurance company CEO doing a presentation for investors.  He boasted that his company was rapidly disposing of all their stock market investments.

I did hold shares of this particular insurance company in several institutional portfolios I was managing at the time, but promptly sold them when I returned to the office.  How much confidence could I have in a management team that sells their assets after they decline?  At the same time I was buying stocks that had been pummeled by the Crash in droves (you can read about this story in my book) even though it almost cost me my job.  My boss, who was also spooked by the October Crash, thought I was bonkers.

Strategies to avoid risk after-the-fact are polluted by recent experience.  The following news prompted this commentary:

Financial Post on Feb 9, 2012: “No financial company wants to lose a CFO especially in the midst of a period of turmoil, but that’s exactly what happened to Manulife Financial Corp. which revealed on Thursday that it’s on the hunt for a replacement for Mike Bell, the highly regarded architect of a hedging strategy that proved key in rebuilding investor confidence in the wake of the financial crisis.”

I believe he is leaving to join his family back in the U.S. as he claims, but his timing could be less than a coincidence.  He was no doubt hired to reduce volatility, but the downside of risk management is removing good (upside) risk just when you want it.

It isn’t widely appreciated (except for readers of this blog of course) that since the summer of 2009 the stock market – partially or fully hedged out by many otherwise smart financial services companies – has managed to give back a great deal of the losses incurred.

To put this into perspective, an ideal hedge would be NO risk at all, so if you had the S&P 500 Index (or an ETF or whatever) back then at the $900 level, it would still be worth $900.  Great news no?

But without the perfect hedge against volatility (detect a note of sarcasm?) you would have instead suffered a 50% rate of return to the current $1350 level.

Bottom line?  If my job had been to wrestle market risk under control in 2009 I surely would get the heck out before someone can measure the damage I’d really done avoiding volatility.

Invest to Live, Live to Ride