Practical Portfolio Performance Measurement and Attribution, 3rd Edition

5Risk

I am always doing that which I cannot do, in order that I might learn how to do it.

Pablo Picasso (1881–1973)

Do not worry about your difficulties in Mathematics. I can assure you mine are still greater.

As far as the laws of mathematics refer to reality, they are not certain, and as far as they are certain, they do not refer to reality.

Albert Einstein (1879–1955)

If you torture the data long enough, it will confess.

Ronald Coase (1910–2013)

DEFINITION OF RISK

Risk means very different things to different audiences at different times; risk is truly in the eye of the beholder. In the context of asset management, the Oxford English Dictionary provides a surprisingly good definition of risk:

The potential impact of an event determined by combining the likelihood of the event occurring with the impact should it occur.

Risk is the combination of exposure and uncertainty. As Holton¹ so eloquently points out, it is not risky to jump out of an aircraft without a parachute because death is certain. Holton also points out that we can never operationally define risk; at best, we can operationally define our perception of risk.

Another common and effective, but broader definition of risk is exposure to uncertainty.

Risk types

Within asset management firms there are many types of risk that should concern asset managers and senior management. For convenience I've chosen to classify risk into five main categories:

1. Compliance risk
2. Operational risk
3. Liquidity risk
4. Counterparty ...