Our urge to measure things is a good one. Measurement provides a sound basis for action, the temperature today, the price level, GDP, and accounting earnings. It is part of “what we know” versus speculation…a forecast of the temperature next week, the price level next year, the GDP next year, and accounting earnings for the future. But the quality of a measure must be understood and, when it comes to earnings, chapters 9 and 10 stress that measurement.
The same applies to risk measures. In an enormous effort to get precision, modern finance has developed risk measures for investors, the CAPM beta being just one of them. It has not been a very successful effort. On reflection, it is unrealistic to think that the many risks that a business faces2Mproduct risk and its many dimensions, supply risk, regulatory risk, currency risk, leverage risk (to name a few)2Mcan be reduced to just one number, beta or similar. That can be done by making assumptions (a probability distribution), but that’s a cop out. To think we can say the cost of capital is 8% and not 7% or 9% is rather naïve. Beware.
In the 1990’s, John Meriwether, former head of bond trading at Salamon Brothers, got together with a couple of academics who had received Nobel Prizes for their work on risk and asset pricing to form a fund called Long Term Capital Management. The fund’s strategy was to find arbitrage opportunities where the prices of securities relative to each other could not be explained by difference in risk measures. The fund’s name turned out to be a misnomer. After three years of outstanding returns with the fund growing to $100 billion, the strategies went against them in 1998. The fund collapsed, nearly bringing Wall Street down with it if it weren’t for a rescue arranged by the New York Fed. The fund’s strategy turned out to sophisticated gambling under pretense of modern finance theory. Beware.
The episode minds us to wary of models, including the models of modern finance.
(The two academics were Robert Merton and Myron Scholes. Their theoretical work is wonderful, an important contribution to the theory of finance. In their work, these gentlemen taught us how to think about risk, and some of that thinking is in chapter 8. The two were also behind the thinking for Black-Scholes option pricing model that does work!)
See the book, When Genius Fails by Peter Lowenstein and the Wikipedia entry on the episode.