As a master of the Impressionist style of painting, Pierre-Auguste Renoir excelled at capturing movement to convey perception and experience in his paintings. In order to be effective, risk managers of today must utilize their perception of the quantitative factors and qualitative experience of their craft to address price movements in the financial markets, argues Stan Beckers, managing director of BlackRock Solutions for the EMEA region. In a session yesterday at the 64th CFA Institute Annual Conference, Beckers argued that, to a certain extent, good risk management is as much an art as it is a science.
Beckers says that investors have to stand apart from the herd to see the warning signs of impending financial challenges. In the run-up to the recent financial crisis, several managers did — and netted billions for their prescient calls. Many others, of course, were not as well positioned and suffered severe losses.
Could those losses have been avoided or minimized? Beckers believes history is a rather poor guide for the future because financial markets experience different regimes in which price movements and correlations change dramatically. Risk management strategies developed during a “steady state” regime, which tends to be present most of the time, provide an unrealistic estimate of the downside risks that are present during a crisis regime, which tends to occurs only occasionally but can severely damage returns.
In other words, even though lots of nickels can be picked up in front of the steamroller, so to speak, during good times, investors run the risk of an “unknown unknown” that can trigger crushing losses (case in point: the Long-Term Capital Management debacle).
Although risk models continue to improve, Beckers believes that effective risk management cannot rely on mechanical approaches. It is difficult to model a meltdown that has never happened and anticipate the resulting impact on prices, correlations, liquidity, and other factors. This is especially true in the face of changing market psychology and behavioral factors.
“Mechanical approaches will fail spectacularly when failure matters most,” Beckers asserted. By using the experience and perceptions provided by the analysis of differing market regimes, he argued, risk management can become a more effective tool.