Financial Risk Management, like any discipline, has its limitations. Understanding how to manage financial risk simply involves developing a proper appreciation of these limitations. Few understand this better than Wiley author Thomas Coleman, who shares 5 Misleading Criticisms of Risk Management.
1 Risk Models May Not Capture All Risks
The models used to measure risk will never include all risks. Nobody should be surprised. A risk system should be viewed as a tool for summarizing and aggregating a large amount of information in a concise manner. Such a system will not be perfect, and users should recognize that in using the results.
2 Risk Measures Such as VaR and Volatility Are Backward Looking
This is simply the way the world is: we can seek to understand the past, but we cannot know the future. Understanding the past is terribly important because understanding current exposures and how they would have behaved in the past is the first step toward managing the future. As the philosopher George Santayana said, “Those who cannot remember the past are condemned to repeat it.”
3 VaR Does Not Measure the Worst Case
Statistical measures will never tell us the worst case. Whatever VaR level we choose, the world can always throw something worse our way. Although VaR is often referred to as a “statistically worst-case loss”, doing so is both intellectually lazy and dangerous. It is intellectually lazy because a so-called worst case relieves us of the responsibility for thinking of the consequences and responses to yet worse outcomes. It is dangerous because it is certain that results will, at some point, be worse.
4 Quantitative Techniques Are Complex and Require Expertise and Experience to Use Properly
The financial business overall, not just risk measurement, is complex and is becoming more complex all the time. Managers at financial firms should take their responsibilities seriously and learn enough about the business, including risk measurement, that they can effectively use the available tools. Risk professionals have the corresponding responsibility to explain their techniques and results to nonexperts in a simple, concise, transparent manner. Simple ideas, clear presentation, and concise description must be the goals for anyone engaged in measuring risk.
5 Quantitative Risk Measures Do Not Properly Represent Extreme Events
Quantitative risk measures do not catch extreme events. Experience does not catch extreme events. Imagination can try, but even that fails. Extreme events are extreme and hard to predict, and that is just the way life is. We need to recognize this limitation, but it is hardly a failure of risk techniques. To criticize the field of risk measurement because we cannot represent extreme events very well is just silly, like criticizing the sky because it is blue. Anybody who does not like extreme events should not be in the financial markets. Luck, both good and bad, is part of the world. We can use quantitative tools to try to put some estimates around extreme events, but we have to learn to live with uncertainty, particularly when it comes to extreme events.
A Proper Appreciation of Risk Management Limitations
A key component of true risk management is an appreciation of not only the power but also the limitations of quantitative risk techniques. Quantitative techniques work best in the hands of those who are keenly aware of the limits and boundaries of what these techniques can provide. A deep appreciation of the limitations gives us the confidence to rely on the techniques when appropriate and the good sense to turn elsewhere when necessary.
The existence of limitations is not a problem. Failure to appreciate our limitations, however, is a serious mistake. Overconfidence in numbers and quantitative techniques and in our ability to represent risk, extreme events in particular, should be subject to severe criticism because it lulls us into a false sense of security. Understanding the limitations, however, does not mean throwing out the tools that we have at our disposal, even if they have limitations.
Keep Reading at Capital Exchange Blog for the Full Article>>
Thomas S. Coleman is the author of Quantitative Risk Management + Website: A Practical Guide to Financial Risk. He has worked in the finance industry for more than twenty years and has considerable experience in trading, risk management, and q
uantitative modeling. Coleman currently manages a risk advisory consulting firm. He is also the author, together with Roger Ibbotson and Larry Fisher, of Historical U.S. Treasury Yield Curves.
Download a preview chapter of Quantitative Risk Management to learn more: Risk Management vs Risk Measurement Chapter 1 Sample>>
Replies