Of Presidents and Heart Attacks

Risk control as diversification through time

Capital Fund Management

In this short note we briefly introduce “risk” (for those readers unfamiliar with the concept and how it is defined); show conceptually how we are able to forecast and control it (for those concerned about risk in their portfolio and how it may be mitigated); and highlight, through a set of historic events, how even a risk-controlled portfolio remains at the mercy of unpredictable and idiosyncratic events.

Introduction

In common parlance, risk is simply the possibility of loss. Losses may stem, predominantly, from two sources: uncertainty about the 1) direction of expected returns, and the 2) magnitude of returns. While the former (alpha) is difficult to harvest and maintain, the latter (volatility) displays certain features that facilitate the forecasting, and thus controlling of the magnitude of investment moves.1

The question of risk and volatility has occupied some of the most celebrated minds in finance and economics for the better part of 70 years. Most of the seminal work still cited today reads like a who’s who of Nobel Prize winning economists: Markowitz, Sharpe, and Engle2 to name but a few, all toiled to understand the nature of risk, and sought appropriate models to measure and forecast it.

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