The Money Formula

CHAPTER 3Risk Management

“ANTONIO:

… I thank my fortune for it,

My ventures are not in one bottom trusted,

Nor to one place; nor is my whole estate

Upon the fortune of this present year:

Therefore my merchandise makes me not sad.”

—Shakespeare, The Merchant of Venice, Act 1, Scene 1

“Risk–reward.”

—Response to the survey question: “How would you describe quantitative finance at a dinner party?” at wilmott.com

Investment advice used to be simplistic. Don't put all your eggs in one basket, or, as Mark Twain said, “Put all your eggs in one basket, and then watch that basket.” There was little in the way of quantification. In the 1950s, economists began to apply probability theory to the problem of asset allocation, and showed how to put numbers on concepts such as risk and reward. Asset managers now had a way of quantifying their strategies. The seeds were being sown for a dramatic shift from finance as art to finance as science – or at least, something that looked a lot like science. But can risk and reward be reduced to hard numbers?

It's a feeling in the pit of your stomach, or a light-headedness. Perhaps a sudden chill, or worst of all the three-o'clock-in-the-morning cold-sweats panic attack. The risk in your portfolio has just been realized and it's much worse than you feared.

Human beings are very poor at estimating probabilities. We tend to be optimistic about our investments, and even the most pessimistic of us is usually pessimistic about the wrong things. So shocks ...