"The Risks You Don't Know"

Are you measuring the right kind of risk when you optimize portfolios?

In my unsophisticated opinion, that was the main point of Dr. John Blin's presentation on "The Risks You Don't Know: Why using a robust risk model should be a part of your investment process." He made this presentation to the Boston Security Analysts Society on January 9. Dr. Blin is chairman of APT, Inc.

This information has practical implications.

For example, a typical fund of funds investing in hedge funds would allocate a big chunk of assets to convertible arbitrage funds. Using risk as Blin defines it, convertible arbitrage funds would virtually disappear from the allocation.

The firm's website describes "The APT Approach" in more detail.

Dr. Blin was kind enough to comment on this article prior to posting. Here's what he said:

I would simply add that this is not only when you optimize. The question: “know WHICH risk” (systematic –un diversifiable; or “specific” “diversifiable) applies whenever you talk about risk. The only reason one takes the optimization case as an example is that optimizers using a factor-model based covariance matrix effectively seek to maximize the share of diversifiable risk in the total risk (and conversely minimize the share of non diversifiable risk)

So if you miss the mark on one type of risk v. the other optimization can actually make matters worse.

But the general central point is that when talking about risk the kind of risk is the central issue. And any estimate of risk that doesn’t’ get that right will be way off the mark –extreme events will be the rule not the exception!

Hope that helps

John