This archive report was first published on 3 December 2019.
On December 3, 2019, RUFUS MWANYASI wrote in Ideas & Debate that measuring market risk is a path rife with dangers.
Market risk is not the same as volatility, which is easily quantifiable. Instead, it's a schooled guess of future risk, and our reliance on 'historical-based' risk measures may be unfounded when the future is full of uncertainties.
Value at Risk (VaR), a key measure, is highly subjective and often fails to account for lack of liquidity. It's also known to underestimate the frequency of extreme events, oversimplifying the picture of risk.
Standard deviation, which assumes a normal distribution pattern, is problematic because extreme stock returns occur more frequently than expected. Asset-class return distributions have fat-tails, with a lot of unknowns at the ends.
The Sharpe Ratio, which shows how much additional return we earn by taking additional risk, has attracted criticism for being useful in comparing different portfolios. Research shows that it assigns the same score to horribly different portfolios, measuring risk inaccurately.
Beta, another useless metric, is not a good predictor of future beta for stocks. Past beta eventually reverts back to the mean over time, meaning that higher betas will tend to fall back toward 1 and lower betas will eventually rise toward one.
Investors need to understand that risk management is more art than science, requiring human judgment. Theory is only theory, and perhaps the greater risk lies in relying too much on magic numbers.
