Risk Management: Foundations for a Changing Financial World

CHAPTER 11

WHAT VOLATILITY TELLS US ABOUT DIVERSIFICATION AND RISK MANAGEMENT^k

Max Darnell

In the aftermath of the financial crisis that began in late 2007, many have wondered why none of the sophisticated risk models predicted the crisis. But it may be that investment managers are expecting too much from risk models. Risk models are helpful in judging risk exposures under typical situations. But no substitute for investment judgment exists when it comes to anticipating how portfolios will respond to tail events.

I want to address four timely, relevant questions in this presentation. First, did diversification fail? Second, did risk models fail? A lot has been said about risk models and their alleged failure to predict the risks that have occurred. The third question is, Was the magnitude of the risk really unprecedented and should it have been such a surprise? Or to what degree should the risks have been expected in magnitude if not in timing? Predicting risk is very difficult, but understanding how it behaves when it does appear is something that we can discuss. And fourth, were investors overly exposed to tail risk? This question is very important now because many expect much risk will remain in the markets for some time to come.

DID DIVERSIFICATION FAIL?

From the standpoint of the beta or asset allocation level, diversification did not fail. To better answer the question, I want to discuss what is meant by beta. Beta is exposure to nondiversifiable or systematic risk, and ...