Managing Risk: Exploring the Realm of Possibility, Part I: Understanding the Nature and Source of Potential Volatility
Risk management is a hot topic as of late. The market crisis of 2008 and 2009 raised the topic to a new level of importance. In the process, new ideas about risk management have emerged, and many people are modifying their definition of risk and their approach to managing it.
Adoption of portfolio theory across asset classes led to the practice of using benchmarks to represent risk and return expectations (beta) and deviations from the benchmark (alpha) to measure manager effectiveness and/or additional risk. Recent thinking is moving away from that view and instead embracing the absolute risk associated with assets. Focusing on absolute risk allows for contemplation of the realm of possibility. Understanding of the fundamental variables in each asset class (and the external variables affecting each) is the basis for estimating the degree of risk we bear.
Risk management requires a set of tools to measure risk exposure and an understanding of the nature and source of p