…was lookin’ for risk in all the wrong places,
Lookin’ for risk in too many faces,
searchin’ their eyes and lookin’ for traces
of what I’m dreamin’ of.
-Lookin’ for Love, Johnny Lee
Risk will surprise you. It is supposed to do this. While we always think of volatility as risk, the real measure of risk is the downside surprise that moves markets beyond what volatility expects. Risk is really when you expect certain scenarios and pay-offs and the actual event is much different and not anticipated.
This is why the core risk management tool has to be diversification. Diversification protects you from the risks that were not anticipated. You can search for risks, but you generally will not find the harmful ones in time to adjust your portfolio. You may identify the risks, but you may not get the timing right for the events.
Of course, we are now hearing from all those astute managers that fully anticipated the equity decline, but in reality, the size of the decline caught most by surprise. It was beyond the volatility measures used at the beginning of the month. There were some clues, but most of the evidence did not suggest a reversal of the year’s gains. Diversification was the only way to escape the decline.