Risk management is a topic few investors discuss when markets are rising but everyone talks about following events such as the credit crisis that began last summer. At the moment, many market participants seem to believe that the most intense phase of the credit crisis is behind us, even though this is far from certain given the recent weakening US economy, concerns of further write-downs at big banks worldwide and credit concerns surfacing at major corporations with a global reach. Nevertheless, many central banks, including the US Federal Reserve, have shifted their rhetoric (and in many cases policies) from crisis-motivated credit loosening to inflation-inspired credit tightening.

While the credit crisis blame game has already started, with news of aggressive mortgage lenders facing charges and credit-based hedge fund managers being paraded before CNN cameras, determining whose fault it was does little to help investors stung by the crisis. At this stage, what could be more instructive is to look at some of the risk management lessons that might be gleaned from investors’ experience over the past year.

While some investors successfully avoided the subprime market, few could have foreseen the extraordinary succession of events that followed. Many investors had no idea how much risk was built into the asset-backed commercial paper market, for example. And even fewer investors had any sense of how problems in the relatively unscrutinised subprime market could spread in so many directions to create the worst liquidity crises since the Great Depression. To have connected all the dots, someone would have had to have been awfully lucky or extremely prescient.

The crisis demonstrated what some market researchers have already pointed out: financial outcomes are not normally distributed, they display ‘fat-tailed risk’ far more often than we think. Black swans, though rare, are always possible.

When analysing a range of potential scenarios, investors need to make sure that they do not just focus on how a position will respond to a three-standard deviation move; they also need to ask how it may be affected by a more tumultuous outcome.

This crisis will force investors to develop better modeling of infrequent, but extremely violent events. Models should do a better job of identifying ‘points of inflection’, warning signs that risks are increasing or lessening, as it is impossible for portfolio managers to always be positioned for the worst-case scenario. Taking risk is a portfolio manager’s job. New tools should help to better calibrate this risk.

Ineffective and poorly-incentivised credit rating agencies will likely take a place alongside overly aggressive mortgage lenders and over-leveraged hedge fund managers in the credit crisis hall of blame – or at least they should. Investors want credit agencies to acknowledge that their models did not adequately capture the potential risks. Over-collateralisation and diversification within AAA-rated tranches of asset-backed securities proved defenseless against the rapid, precipitous, and all-pervasive nature of vanishing liquidity.

It is now clear that rating agencies’ risk models dealt with a narrow range of assumptions about correlation and did not have provisions for stress environments in which correlations are much more dynamic. From their experience we learn to avoid over-reliance on one type of risk assessment or model. Assessing risk is complicated, and investors benefit from multiple perspectives – fundamental, quantitative, macroeconomic – and from scenario testing that integrates all of these perspectives.

One lesson that is always applicable is: if something seems fundamentally unsustainable, it most probably is. But it is not as easy as that. An investment asset or strategy that is ultimately bound to fail can still run for many years before the inevitable happens. It is hard to tell when an overpriced asset will deflate. That means investors avoiding something on the basis of apparently unsustainable fundamentals could underperform the market for a painfully long time.

The good news is that most fundamentally-focused investors avoided many of the worst problems of the credit crisis directly even though they may have been ensnared in the unforeseen liquidity crisis. In addition, it is important to keep in mind that fundamentals have always eventually prevailed, therefore, patience and a long investment horizon are helpful.

Another risk management principle, related to the ‘fundamentals don’t lie’ maxim, is to avoid investments that you do not really understand or that cannot be fundamentally analysed. The best way to manage risk is to know what you own. If you don’t have the tools or transparency to do the analytical work then steer clear and do not rely on the credit rating agencies to do your homework.

In the vast majority of economic and financial environments, the key to risk management is to be truly diversified. Do not just focus on being diversified on paper, but make sure that your holdings are not highly correlated with one another. You may need to conduct a ‘what if’ analysis that can try to predict or answer questions, such as: “how will all of my different baskets react to this or that event?” If they all react the same way, you are not diversified.

While some of the more exotic structured fixed income investment vehicles that were introduced in the past economic expansion will disappear, there will certainly be other exotic investment vehicles to take their place. Unfortunately, history has shown that these crises tend to repeat.

The problem is human nature. We are subject to the same kind of social behaviour as people were 100 years ago during the panic of 1907, or almost 400 years ago during the Dutch tulip bubble. Regulatory agencies need to get ahead of the market and anticipate events instead of reacting to them. Admittedly, this may be a tall order for regulators, but we really should be able to recognise these patterns and at least lean against the wind to limit the almost certain negative outcome of excesses.

In the meantime, investors need to be vigilant in managing risk, and try to anticipate rather than only react.

Investment processes need to be disciplined and systematic; they need to account for behavioural biases and seek to overcome them.

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