Reassessing investment risk

by Dr. Ros Altmann

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Sir

May I suggest that today’s financial crisis stems not from ‘mispricing’ of risk, as suggested in Professor Sohn’s defence of modern financial theory (letters, Dec 11) but from ‘misunderstanding’ the concept and nature of investment risk. Theory only states that investors – on average – have a chance of achieving higher returns. Some will fail – that is why there is a risk. Theory has no predictive power for individuals, firms or funds, many of whom will find ‘expected’ returns are not their own ‘achieved’ returns. Unfortunately, this subtlety was overlooked.

Whether in banks, trading houses or pension funds, probabilities of reward were considered virtual certainties, leading to insufficient protection against failure. Volatility of return is only one measure – capital loss is far more important. Banks thought that, as long as they had sufficient diversification of risky assets or loans, they could rely on their models’ predictions of negligible risks of loss at the aggregate level. Pension funds believed, as long as they could wait for the long term, they would always be rewarded for stock market investing. This over-confidence about returns was self-serving, of course, but should never again be permitted to dominate financial behaviour. Diversification and downside protection are vital. The trick is to find optimal ways to achieve this.

Yours faithfully

Dr. Ros Altmann
London School of Economics
c/o 9 Fairholme Close
London N3 3EE