Financial news

Risk management is still an art as well as a science. We have seen the use of sophisticated models based upon correlation between different risks and assets. Many of the parameters are numerical and objective. These provide real benefits when applied properly. We also have to realise that these tools only handle certain types of risks adequately, mainly market and credit risk. When new products are introduced and increasing complex financial modelling overawes us, we deem it fit to call in the investment risk experts.
If computers and automatic limit systems worked all the time, then no one would have to go outside for specialist help, except for the occasional risk management and dealing system supplier. Mechanical-type systems only account for a small part of the entire risk management business process. Many companies do not possess all these skills in-house and there are reasons why they must hire outsiders.
This means that in major change projects, some element of accountability and control are reduced because of taking in outside help. Also, cost-effectiveness is not the top criterion in these projects at all. In essence, it is ironic that we hardly place checks and controls over those who are hired to control our errant staff.21
More products and mathematical modelling techniques are brought on the market every year. This creates a buoyant market in certain dealing areas. The prospects for derivatives and futures contracts are bright in many ways, but what do they offer fund managers in the way of real value? Many are confused as to the exact answer, so they bring in outside derivatives experts to help them. Some of the problems lie in the complexity of these financial instruments, the extreme leverage they can possess and the manner in which people have been mis-selling them. The deep mathematical foundations underpinning derivatives and financial futures instruments mean that more scientific knowledge is needed to understand them. Thus, a breed of mathematicians and intellectuals sometimes known as “rocket scientists” or “quants” appeared in various brokerages, banks and funds. Investment risk is not a question of solving solely by mathematical or scientific means. Nevertheless, the use of mathematics in investment theory seems to be addictive for many.
So, we have to identify the risk style of the professional investment manager. Then, we have to pick the type of fund that our risk appetite allows. It seems that many investment meals do not match the risk appetite appropriately. Another critical look at the menu can rebalance the investment fare.

There are two basic approaches to financial markets and their fundamental logic. The first (which will be considered again when we analyze investor behavior, corresponding to passive or index fund management) draws on double diversification in space and time. Diversification in space involves a multitude of financial instruments designed to reduce the risks proper to each and to accept only non-controllable, systematic risk. When investing in stocks you should remember that it is important to diversify into more than 20 of them to make the most of the diversification effect in accordance with the correlation existing between these different stocks. However, this is equally the case when you invest in gold, real estate, bonds or Treasury bills.
Concerning possible stocks, observe the way in which the firm defines its ‘‘corporate strategy’’. Choose those that are focused, as Zook and Allen showed,33 on expanding and innovating in and around their core business. It is up to the investor – and not to the company – to diversify. Such reduction of risk is accompanied by diversification in time; you have got to invest over a long period. If you go for the long haul, you tend to render your investing steadily less hazardous. This is a form of passive investment corresponding both to Warren Buffett’s practices and to the classic definition of the speculator. Speculate on the future, invest and stay invested.
The second approach is more speculative in the sense of speculum, a mirror; Keynes’s beauty contest comes immediately to mind. In this case, a speculator buys stock only for the sake of short-term capital gains rather than for long-term income. Keynes used the term ‘‘speculation’’ for the activity of forecasting the psychology of the market and ‘‘enterprise’’ for the activity of forecasting the prospective yield of assets over their whole life. He despised speculators’ gambling instincts. He felt that they were simply trying to outguess and outwit one another ‘‘to beat the gun’’, rather than striving to project and compute the cold mathematics of future cash flows and associated risks. This analysis explains the highly erratic stock variations registered from one day to the next. Keynes claimed that the valuation of capital assets consequently established was ‘‘arbitrary’’ in so far as it had devolved into a forum for speculation rather than entrepreneurship. This is still the case. But since Keynes’s time, the financial world has learned how to measure the state of confidence with which we forecast the prospective yield of financial assets over their whole life. We now know that long-term investment in a well-diversified portfolio bolsters our confidence in financial investments. Within this framework, the selection of assets relies on more subjective and qualitative factors.
Thus there are two approaches at work. The first is long and diversified; the second is necessarily limited in time. There exists a quantitative philosophy predicated on the past history of returns and volatility as well as indicators of responsiveness such as the beta coefficient. There also exists a qualitative philosophy through which one endeavors to identify factors that will orient prices in the near future. In the end these two philosophies come together. Expectations for the future are based on statistical analysis of results recorded in the past. The short-term qualitative approach fits into Chinese boxes with regard to the long-term quantitative approach. Asset allocation is in conformity with long-term quantitative analysis and selection of individual assets remains qualitative and short term.