In his 2003 memoir, former Treasury Secretary Robert Rubin wrote:
There is one type of financial risk, the risk of remote contingencies — which, if they occur, can be devastating — that market participants of all kinds almost always systematically underestimate. The list of firms and individuals who have gone broke by failing to focus on remote risks is a long one.
This is smart, but depressingly ironic. While writing the book, Rubin was chairman of the executive committee at Citigroup Inc (NYSE:C). Five years later, while still under Rubin’s watch, the bank added its name to the list of firms who went broke (or close to it) by failing to focus on remote risks.
I remembered this story this weekend when reading a blog post from economist Noah Smith, one of the sharper commentators out there. Smith was discussing hedge fund returns (or lack thereof), and wrote:
To evaluate hedge funds — or any investment — you need to look not only at the return, but at the risk. If hedge funds have higher return-to-risk ratios (such as Sharpe ratios) than a passive stock-bond portfolio, then they are a better investment. Why? Because in that case you can borrow money and invest it in hedge funds, and your leverage will increase the returns (and the risk) of the hedge fund investment.
Pardon me, but I disagree.
The problem here is the definition of “risk.” As defined in finance textbooks, including the Sharpe ratio Smith mentions, risk is volatility.
But volatility is a strange way to think about risk. Time and time again, investments utterly implode after periods of silky-smooth calmness.
Take Rubin’s Citigroup Inc (NYSE:C). Before it blew up, it has a long record of stable, consistent profits:
Source: S&P Capital IQ.
Or consider American International Group Inc (NYSE:AIG). Before it blew its top in 2008, the insurer enjoyed two decades of smooth, predictable, volatility-free profits:
Source: S&P Capital IQ.
In each case, equating volatility with risk would have sweet-talked you into a dangerous sense of complacency. The narrative, which is common among large companies, probably went like this: American International Group Inc (NYSE:AIG) earns stable profits year after year. That makes it a safe, low-risk investment. Maybe even safe enough to leverage up on.
And then … boom! Investors lost almost everything overnight.
To be fair, Smith was talking about hedge fund returns, not corporate profits. But there’s a classic example of hedge fund investors getting duped to death by focusing on volatility as a measure of risk.
The hedge fund Long Term Capital Management is now infamous for being the largest hedge fund failure of all time. In 1998, during a period when seemingly no investor could lose money, the geniuses at LTCM — including two Nobel laureates — lost everything. They literally went bankrupt during a period when Barbra Streisand was a successful day trader.
