Radioactive Cold Cream and Rational Volatility

Someday, we will look back at the way capital was allocated, the crude way we invested and estimated risk and thought, how naïve we were, how reckless. Just like in the early days when radioactive materials were discovered and used for cosmetics and novelty items.

radioactive

The lack of understanding of flow, risk modeling, behavioural fallacies, decision making, information asymmetries and political interference contributed to inefficient capital allocation by all agents.

Having said that, here is where we are at on August 2014:

A financial market is a complex system demonstrating diverse phenomena and attracting attention from a whole spectrum of disciplines ranging from social to natural science. Better understanding of the behaviour of financial markets has become an integral part of the discussion on further sustainable economic development.

In this context, proper assessment of financial risks plays a crucial role: Underestimated risks contribute to financial bubbles with eventual crashes while overestimation of risks might cause inefficiency of financial resource allocations and a slowdown in economic growth, giving rise to periods of stagnation.

This multifaceted problem, lying at the core of finance, draws significant interest from the physical and mathematical communities.

One of the key components of financial risk analysis is a volatility assessment, which quantifies the financial stability of an asset in question. Related phenomena, being a result of collective behaviour, also involve such aspects as estimation of correlation and cross-correlation matrices, study of their dynamics asymmetric correlations, nonlinear correlations and de-trending, financial networks and clustering, multivariate stochastic models, critical phenomena, etc.[1]

We have come a long way since the 12th century France where “the courretiers de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks”. As Grinold and Kahn said in their book,

The art of investing is evolving into the science of investing. This evolution has been happening slowly and will continue for some time….As new generations of increasingly scientific investment managers come to the task, they will rely more on analysis, process, and structure than on intuition, advice and whim.[2]

But it also appears that, for the majority of market participants, we may still have a long way to go. There are still many questions left unanswered. For one, should portfolio construction be influenced by quantitative easing? For another, does mean-variance analysis really work? Markowitz, the father of mean-variance optimisation said,

In the right hands, mean-variance analysis is as flexible as a set of oil colours in the hands of Picasso, Van Gogh, or Rembrandt, and in the wrong hands, it’s just paint by numbers and you don’t know what you’re going to get.[3]

Lastly, one pertinent question we should ponder in the current environment:  is volatility in the low teens really just central banks manipulation, or is it actually already a more rational view of true underlying risk and therefore, a more efficient capital allocation?

1. “Cross-correlation asymmetries and causal relationships between stock and market risk”; Stanislav S. Borysov, Alexander V. Balatsky; July 2014.

2. “Active Portfolio Management”; Richard Grinold, Ronald Kahn, 2000 (p.1)

3. “Year in Review 2013”; CFA Institute Research Foundation 2014 (p.50)

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