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Hidden Risks and Biases

What risk systems don’t see

Many investors, trading floor managers, fund of fund allocators and risk managers have at one time experienced unexpectedly large losses that were not predicted by their risk management systems. Some of these losses may have occurred in portfolios, which according to the risk reports only contained very little risk, perhaps they were predicted to be market neutral, well diversified and, until the large loss happened, had only generated very moderate return swings. Then, seemingly out of the blue, this safe portfolio generated large losses and for reasons that were not detected, nor predicted.

Risk systems are today one of the key technologies within financial firms. Risk management guides everything from market exposure to regulatory reporting. Therefore, it is important to know what a risk management system can capture, measure and predict and perhaps more importantly, what it does not capture.

The kernel of this article is to show some examples of risk exposures that can fly below the radar screen of risk systems.

As we will exemplify risk systems can be blind to, and therefore portfolios vulnerable to, risks that systems are not measuring and do not have the capacity to imagine.

What gets measured can be managed and while we may feel safer by improving our risk systems and risk management techniques, they did not stop bank failures in 2008, nor are they likely to prevent or predict the next large dislocation. It is therefore important to broaden our scope of risk awareness to what lies outside the risk management system’s reach.

It is to be noted that some of the risks or biases we describe may be intended components of an investment strategy. Such a discussion about investment expectations and understanding between managers and investors lies outside the scope of this article.

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