Key Risks
Strategy/ manager risks
Our investment strategy is predicated on the theoretical and empirical outperformance of 1) academic risk factors, 2) return premiums, and 3) behavioral basis of investors. While we believe these factors are robust, nobody knows the future.
- Academic factors: size, value, quality,
- Return premiums
- Behavioral factors
General Risks
Volatility
Volatility is typically defined statistically as the standard deviation of an investment’s returns over some period of time. This measures the variability of returns, as a more volatile return pattern is associated with higher risk. However, since standard deviation measures both positive and negative variation, the semi-variance statistic, or downside variation, is sometimes preferable. Volatility is reflective of risk overall and over the long-term, but may present significan opportunity in specific circumstances or over short time periods.
Risk of Ruin
The risk that is unrecoverable. The genie out of the bottle; the loss of absolute trust; the portfolio that goes to zero.
Market / Systematic Risk
Market risk is the core, systematic risk of a given market, often represented by the risk characteristics of a relevant market index. The S&P 500 Composite Index risk characteristics represents the market risk for large cap U.S. stocks. Beta is a statistical term used to measure an investment’s sensitivity with that index.
Idiosyncratic / Unsystematic Risk
Idiosyncratic risk is the risk in a security relevant to only that security, and not to the general market. Therefore, this risk is said to be not related to any “systematic” factors. A stock’s company-specific circumsatnces and risk factors are an example. Finance theory dictates that idiosyncratic risk is easily diversifed away and thus is not compensated by the market.
Fundamental Risk
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Concentration Risk
Large position sizes in a portfolio, be it of individual securities, geographies, sectors, industries, or any dimension very closely related, can create concentration risk: the risk that the whole portfolio can be drag down by just afew elements of it.
Leverage Risk
Leverage magnifies investment gains and lossses. It can transform a good strategy into a poor one, but it almost never transforms a poor strategy into a good one. It can increase drawdown risks
Business / Economic Risk
Securities of companies engaged in highly cyclical, or highly uncertain businesses, have high economic or business risk. Bi-modal outcomes.
Price Risk
Operational Risk
This relates to various operational issues at the fund manager level. What is the potential for operational or regulatory errors, if not outright fraud. Will the advisor be sold or merged away? Is the team susceptible to a star manager departing the fund?
Analysis Paralysis: quantitative framework and reliance on a limited set of parameters helps drive decision-making.
Overconfidence: maximum position sizing
Relative Performance Risk
Small Cap Risk
Small cap companies are not well-followed by Wall Street researchers and are ignored by many large investors. Therefore, they tend to be less accurately priced, and carry a higher degree of risk. Consequently, over long periods of time, small cap stocks usually outperform large cap stocks.
Valuation Risk
Historically, “value” stocks, or cheap stocks, are perceived by investors to be riskier than “growth” stocks. Perhaps investors are enamored with growth companies and thus over-enthusiastically bid up the prices for their stocks. Conversely, perhaps investors fear cheap companies, many which are on the brink of financial distress, and thus overly depress their stocks. Whatever the reason, the result is that historically, value stocks, that is stocks with low valuation multiples (e.g. P/E, P/B, etc.), have convincingly outperformed growth stocks, stocks with high valuation, from both risk and returns perspectives.
Bond Risks
Interest Rate Risk
Bonds are generally most sensitive to changes in interest rates. A statistical measure, duration, calculates the ratio of a givent change in the level of interest rate against the estimated change in the value of the bond investment.
Credit Risk
Credit risk represents the probability that a debtor will be unable to make interestor principal payments on a debt. Bonds are rated by agencies, typically from AAA to CCC, indicating the credit quality of the borrower. Bonds with higher credit risk, or higher likelihood of default, offers compensation in the form of higher yields.
Inflation Risk
Inflation is the silent killer. It slowly depletes the purchasing power of money without large fanfare. Inflation risk can be mitigated to some extent by investing in inflation-protected securities, such as TIPS.
Agency Risk
This is the risk when you hire an advisor or any agent to act on you rbehalf. How can confident are you that the agent will always act in your best interest? What results when the agents interest conflcts wiuth your best interest? This risk can only be mitigated by employing the most honest agents or by structuring the agent’s incentive to match your own, hoping that his rational self interest will also protect yours.
Information Risk
The risk that the information you use to make an investment decision is misleading, inaccurate, or plain wrong. One must be mindful of the sources or information used, the soundness of the anlaytic process used to process the information, and be aware of the potential assymetry of information between you and the counterpart you are transacting with.
Liquidity Risk
The possibility that an investment cannot be sold, or cannot be sold for a favorable price, when it is desired to be sold.
Investor Risks
Shortfall Risk
The risk of inadequate returns or portfolio value to meet obligations.
Behavioral Risk
Succumbing to human psychological weaknesses, such as panic and euphoria, overconfidence; and common biases, such as recency bias, anchoring, etc.
| Risk Factor | Primary Source | Secondary Source |
| Equity | stocks | real estate (REITs) |
| Interest Rates | bonds | real estate |
| Inflation | bonds (nominal) | commodities |
| Currency | bonds (international) | stocks and commodities (international) |
| Credit | high yield bonds, small company stocks | bank loans, stocks |
| Leverage | real estate, derivatives, structured product | commodities, bank loans, certain hedge fund strategies |
| Momentum | commodities | quantitative strategies, stocks |
| Liquidity | private equity, distressed debt | private real estate, micro-cap stocks |