What is Risk ? And the Case for Redefining Risk

In the world of finance risk has become synonymous with volatility. But is volatility a good measure of risk? Quite simply it’s not.

Beta is currently the financial industry’s main way to measure volatility and hence their version of risk. A Beta greater than1 means the security is more volatile than the market average. A Beta smaller than 1 means the security is more volatile than the market. Because an asset class has a low beta does not mean its safer.

For example when examining the stocks of financial companies most have a beta smaller than 1. Does that mean they are less risky? The answer is simply no. Different companies have different risks.

Financial companies, typically considered a “conservative” investment, have a special type of risk, that of leverage risk. For example a quick look at BMO’s balance sheet tells us that they have 377 billions in assets and 360 billions in liabilities, leaving the company with 17 billion in equity. In contrast EnCana has 47 billion in asset and 26 billion in liabilities leaving them with 21 billion in equity. A 4.5% drop in asset leaves BMO with no equity while it is 45% for EnCana. All you need is 4.5% of assets (i.e. mortgages, loans and other investments) to go default and BMO will no longer exists. The dangers of being leveraged has recently been observed with the recent asset write downs at many large US financial institution due to the current credit crisis. This has resulted in many firms panicking and looking abroad for capital (i.e. from Dubai and Singapore) to shore up their balance sheets. Leverage is not only dangerous when asset values decline at banks, but leverage is also dangerous if liabilities (i.e. deposits) decrease which can result in a bank run, as recently observed at Bear Sterns. In the case of BMO a 9.5% drop in deposits (about $22.8 billion) will leave BMO insolvent.

As investors it is important that we understand the risks implicit in different types of investments instead of relying only on Statistical Analysis such Beta, Standard Deviations and Probabilities which are all based on previous performance. And because pass performance and volatility is not indicative of future performance and volatility we should take most statistical analysis with a grain of salt. Many risks have to be analyzed when investing, a few are outlined below:

1) Bonds are subject to inflation and interest rate risks.
2) Financial and commodity companies are subject to leverage risk.
3) Commodity companies are subject to commodity price risks.
4) Companies are exposed to management risk.
5) Foreign companies are subject to currency risks.

If investors continue under the current statistical paradigm of analyzing risks, while ignoring and failing to analyze real risks it can leave investors vulnerable to loses such as those in financial companies over the last year.