The market can remain irrational longer than you can remain solvent.
—John Maynard Keynes
Risk management should not be thought of solely as the avoidance of risk or reduction of loss. It is about the intentional selection and sizing of exposures to improve the quality and consistency of returns. In Chapter 3, we defined alpha as a type of exposure from which a quant trader expects to profit. But we also noted that, from time to time, there can be a downside to accepting this exposure. This is not what we classify as risk per se. By pursuing a specific kind of alpha, we are explicitly saying that we want to be invested in the ups and downs of that exposure because we believe we will profit from it in the long run. Though it would be great fun to accept only the upside of a given alpha strategy and reject the losses that can be associated with it, sadly, that is not possible. However, there are other exposures that are frequently linked to the pursuit of some kind of alpha. These other exposures are not expected to make us any money, but they frequently accompany the return-driving exposure. These exposures are risks.
Risk exposures generally will not produce profits over the long haul, but they can impact the returns of a strategy day to day. More important still, the quant is not attempting to forecast these exposures, usually because he cannot do so successfully. But the fact remains that one of the great strengths of quant trading is to be able to measure ...