Risk Is Always On

When anyone refers to the daily price action in financial markets as “risk on,” it makes me to lose my freaking mind! Like being forced to watch all of the NBA Finals games from the 80’s when the Lakers lost to the Celtics, while simultaneously listening to the Beaches soundtrack on repeat. It drives me crazy! There is no such thing as financial market risk being “on” or “off.” This isn’t the Karate Kid, you aren’t Ralph Macchio and I’m sure as heck not Mr. Miyagi. Risk on, Risk off Daniel-son.

Risk is always on my friends. The problem is that most investors have no idea what the word “risk” really means. I’m going to do my best to awaken the risk manager that lies dormant inside you. But be forewarned, once awakened, you won’t like what you see in financial markets right now.


Bless Your Heart

Raise your hand if you’ve ever been put to sleep by your finance guy spewing terms like beta, standard deviation, kurtosis and skewness. I feel your pain. There is nothing finance-types like more than tossing impressive sounding words around, knowing that most people don’t truly know what they mean, the finance types included!  Like when a Southerner says “bless your heart,” knowing full well that non-Southerners have no idea that they were just insulted.


A lot of the confusion comes from the fact that the words “risk” and “volatility” are used interchangeably. Let me be clear, risk is not volatility, they are two different beasts. Standard deviation and other measures of volatility are not measures of risk. These calculations may make you feel warm and cozy but they can’t help you understand risk because risk is not a number. I like how Howard Marks puts it, “Because the underlying processes that affect economics, business and market psychology aren’t 100% dependable, then the future isn’t knowable, which means that risk can only be an estimation.”


So, what exactly is risk? 


Risk is uncertainty about the likelihood of a permanent loss of capital if an unfavorable event occurs.


I’ve left you wanting, haven’t I? You wanted me to tell you the index, calculation or statistical measure that would help you discern just how much risk exists in the world and more importantly, in your portfolio. I’m sorry but I can’t. We can’t boil risk down to a number but we can assess the probabilities of various outcomes and then position our portfolios in a way that tilts the scales in our favor. This assessment of risk allows us to either side step danger or allows us to Crane Kick the crap out of a trade and book a profit.


If you are using volatility measures to determine how much risk is in markets, or your portfolio, then you are being taught karate at the Cobra Kai dojo. You might kick butt and take names for a while, but we all know what happens in the Championship Bout. You get your butt handed to you by a 135-pound kid who normally gets sand kicked in his face at the beach.


If you want to be a successful investor, it’s critical that you use a process for understanding risks that can’t be quantified. My 3-G framework was developed to help me monitor and better understand a wide range of risk sources. Here are a few risks that I’m seeing right now, which will give you a better sense of what risk looks like in the real world; outside of the Excel spreadsheet.


Contradiction Risk

I’m not sure there has ever been a time when central bank policy risk was more elevated that it is today. Take the uncertainty surrounding last week’s Fed meeting. The whole world was waiting with bated breath to see if they would or would not raise rates. Once the decision was known, the minutes from the meeting, and Yellen’s testimony were sliced and diced for some indication of a dovish or hawkish slant.

The only thing I learned last week was that contradiction risk is definitely “on.” Yellen stated that their decision to hold rates steady “does not reflect a lack of confidence in the economy.” At the same time, the Fed released updated economic forecasts, which shaved 10% off of their expectations for GDP growth from just 3 months ago. The Fed now sees long-term growth coming in under 2% per year. So, the Fed believes that the US economy will deteriorate further but hasn’t lost confidence in it? How do you quantify “contradiction” risk and the accompanying uncertainty? Beta can’t quantify it, but the risk is real.


Anonymous Source Risk

There is no market on Earth more susceptible to headline risk than crude oil. This risk was on full display last week. Crude was up over 6% entering last Friday and then got hammered by 3.5% in one day. Why? Because an “anonymous source” was quoted by Reuters as saying that the Saudis might be willing to cut production if Iran was willing to do the same.

When this headline couldn’t be confirmed, crude sold off and was down as much as 5% during the trading session. This headline did nothing to change the underlying fundamentals of the crude market but it was enough to punish the market for a day. How can you quantify “anonymous source” risk and the accompanying uncertainty? Kurtosis can’t quantify it, but the risk is real.


Relationship Status Risk

I’m not talking about the kind of relationship risk that occurs when you decide to be honest about whether or not those jeans make her look fat. I’m talking about the relationships between and across markets. Bill Nye the Science Guy would call this “correlation.” Last week, I discussed US Dollar relationships and several weeks back I talked about the relationship between volatility and various financial markets. For those who are new to TWR, right now most of the major markets in the world are moving up and down together, which is not something that normally occurs.

In addition, most of the major markets are moving in the opposite direction of the USD and volatility. Also not something that normally occurs. Last week, every market had gains except for the USD and volatility. Stocks, bonds, commodities, it didn’t matter what you owned, chances are, you ended the week in the green. That’s why most people aren’t concerned about relationship risk right now. But what would have happened if volatility had increased or the USD had been strong? Investors would have freaked out because there would have been no safe place to hide as bonds would have fallen right along with stocks.

There may not be a more uncertain factor in markets than the relationship factor because the status of relationships between and across markets is constantly changing. That’s why correlation is one of the top quantitative factors I monitor as part of the Quantitative Gravity component of my 3-G framework. But even seeing a shift in relationships can’t help you quantify the risk and uncertainty that goes along with those relationship status changes. How do you quantify “change in relationship status” risk and the accompanying uncertainty? Standard deviation can’t quantify it, but the risk is real.



Human beings are hard wired to HATE uncertainty. But if you think about it, there is no great reward if you don’t embrace uncertainty. The first time you asked your significant other out on a date, were you certain she would say yes? Of course not. There was uncertainty and a possible loss of ego if an unfavorable event occurred and she said “no.” If you’re thinking of leaving a 20-year steady paying gig to join a start-up because you want to control your own destiny and earn “buy-your-own-island” money, is there certainty? Nope. My friends, all of life’s greatest rewards live in the land of uncertainty.


An Investor who focuses solely on profits is like Johnny sprinting directly into the Crane Kick even though Daniel-son telegraphed the hell out of that move. In the world of investing it’s always better to deliver the Crane Kick than to receive one. Let’s be honest, every once in a while we all turn out to be Johnny when we try to sweep the leg, and get clobbered. The key to successful investing is to limit the number of times it occurs.  


My 3-G investing framework is not built for profits; it’s built to embrace uncertainty. It is a framework designed to keep us abreast of the ever-changing, dynamic and unintended sources of risk. Profits ensue, but our focus, first and foremost, is always on trying to better understand the potential risks embedded in markets.