CFA Annual Dinner - Volatility, Risk and Permanent Loss of Capital

Last night, we had the pleasure of attending the CFA Society of Washington DC's annual dinner as guests of Ian Asvakovith and his great team at Piedmont Fund Services.  The event's keynote speaker was Cliff Asness, PhD, Managing and Founding Principal at AQR Capital Management.  We've read Cliff's analysis for a long time but this was our first opportunity to hear him in person.

His talk focused on his Top 10 Peeves in terms of commonly held investing beliefs.  The list was definitely thought provoking and grabbed our attention immediately as his first peeve was a topic we've often debated.  It centered on the relationship between volatility, risk and the permanent loss of capital and the widely held concept that the true definition of risk is the chance of losing money and never getting it back.  The peeve which he'd titled as "Volatility is for Misguided Geeks; Risk is Really the Chance of a Permanent Loss of Capital" bugged him for several reasons and one of them particularly resonates with us.  In his words:
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"Think about a super-cheap security, with a low risk of permanent loss of capital to a long-term holder, that gets a lot cheaper after being purchased. I—and everyone else who has invested for a living for long enough—have experienced this fun event. If the fundamentals have not changed and you believe risk is just the chance of a permanent loss of capital, all that happened was your super-cheap security got superduper cheap, and if you just hold it long enough, you will be fine. Perhaps this is true. However, I do not think you are allowed to report “unchanged” to your clients in this situation. For one thing, even if you are right, someone else now has the opportunity to buy it at an even lower price than you did. In a very real sense, you lost money; you just expect to make it back, as can anyone who buys the same stock now without suffering your losses to date.

If you can hold the position, you may be correct (a chance that can approach a certainty in some instances if not ruined by those pesky “limits of arbitrage”). For example, when my firm lost money in 1999 by shorting tech stocks about a year too early (don’t worry; it turned out OK), we didn’t get to report to our clients,“We have not lost any of your money. It’s in a bank we call ‘short NASDAQ.’” Rather, we said something like, “Here are the losses, and here’s why it’s a great bet going forward.” This admission and reasoning is more in the spirit of “risk as volatility” than “risk as the chance of a permanent loss of capital,” and I argue it is more accurate. Putting it yet one more way, risk is the chance you are wrong. Saying that your risk control is to buy cheap stocks and hold them, as many who make the original criticism do, is another way of saying that your risk control is not being wrong. That’s nice work if you can get it. Trying not to be wrong is great and something we all strive for, but it’s not risk control. Risk control is limiting how bad it could be if you are wrong. In other words, it’s about how widely reality may differ from your forecast. That sounds a lot like the quants’ “volatility” to me."

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We are in total agreement with him here and likewise agree that both sides can hold truths on this topic.  However for those (read: the buy-and-hold crowd) arguing that risk is only the likelihood of a permanent capital loss, they seem to be operating under the assumption that their initial forecast of outcomes will absolutely occur while discounting the scenarios of being wrong.  This type of mindset seems terrifying to us and particularly so if a group is operating in a fiduciary capacity and managing investor capital.  There are instances like his tech bubble example where managers had to wait years for their short thesis to be proven correct.  In the meantime, they had to face mounting losses and very likely some incredibly impatient clients.

We believe that one must always be assessing the chances of their thesis being wrong.  Actually, there's likely no better way to gain confidence in your positioning than constantly trying to poke holes in it.  Maybe that makes us seem like wimps but we'll also never be caught operating under the assumption that we're smarter than the market.  And we're fine with that.