Hidden Investment Risks: What You Need To Know

Hidden risks in investment are risks that are not predicted by risk management systems. These risks can result in unexpectedly large losses. They can occur in portfolios that are predicted to be market neutral and well-diversified. For example, a difference in Beta behaviour can result in outsized negative results. It is therefore important for investors to look beyond their risk reports and try to find what other risks and biases they may be exposed to.

Risk systems can't always be relied upon

Risk systems are today one of the key technologies within financial firms. However, investors need to look beyond their risk reports and try to find what other risks and biases they may be exposed to in a portfolio or strategy. This requires experience, imagination and creativity, along with the hard work of analysing traditional risk reports.

For traditional portfolios, a difference in Beta behaviour is likely to be a minor problem. However, for active, more concentrated and leveraged strategies, a difference in Beta behaviour can result in outsized negative results.

To offset the inconsistent diversification value of bonds, alternatives or low-correlating strategies should be explored. Low-correlating assets exhibit a lower or non-existent correlation with traditional asset classes like stocks and bonds. By incorporating low-correlating assets into portfolios, investors can potentially achieve improved diversification and risk management, even when stocks and bonds move in tandem.

Risk reports may not always be accurate

Risk reports are not always accurate because they do not always capture the full picture of the risks embedded in investment portfolios. For instance, a difference in Beta behaviour can result in outsized negative results. During the financial crisis of 2008, Volkswagen's Beta imploded and then exploded, and the possibility of a short-squeeze was not captured by risk systems.

Additionally, hidden biases can exist within portfolios that have different Beta sensitivities on the short and long sides. This can translate into a downside potential that is multiples greater than the upside, even when the risk systems indicate otherwise.

Furthermore, relying solely on bonds for balance across all time periods can be risky. Low-correlating assets, such as alternatives or low-correlating strategies, should be explored to achieve improved diversification and risk management.

As such, investors need to look beyond their risk reports and try to identify other risks and biases they may be exposed to. This requires experience, imagination, creativity, and the hard work of analysing traditional risk reports.

Beta biases can cause higher risk than reported

Risk systems are a key technology within financial firms today, but they are not always accurate. Investors, trading floor managers, fund of fund allocators and risk managers have all experienced unexpectedly large losses that were not predicted by their risk management systems.

Beta is a popular indicator of short-term risk. It measures the systematic risk of a stock and its potential reaction to market changes. A beta score exceeding 1 indicates a higher level of volatility, while a score below 1 indicates lower volatility. However, beta is based on historical data and doesn't anticipate future price changes.

To avoid hidden risks, investors need to look beyond their risk reports and try to find what other risks and biases they may be exposed to in a portfolio or strategy. This requires experience, imagination, creativity and the hard work of analysing traditional risk reports.

Bonds may not be a reliable diversification strategy

Risk management systems are today one of the key technologies within financial firms. However, 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.

One example of this is the stock of Volkswagen, which was subject to a takeover bid by Porsche combined with a so-called short-squeeze. Volkswagen’s Beta both imploded and then exploded during the financial crisis of 2008. The possibility of a short-squeeze was not captured by risk systems.

To have different Beta biases on the short and long side of the portfolio can indeed be a conscious part of an investment strategy. However, this results in a portfolio with a higher risk than the risk report shows. For active, more concentrated and leveraged strategies, a difference in Beta behaviour can result in outsized negative results.

Leveraged hedge fund portfolios can have hidden biases

Hidden risks in investment are risks that are not predicted by risk management systems. Investors, trading floor managers, fund of fund allocators and risk managers have all experienced unexpectedly large losses that were not predicted by their risk management systems.

To avoid hidden risks in investment, investors need to look beyond their risk reports and try to find what other risks and biases they may be exposed to in a portfolio or strategy. This requires experience, imagination, creativity and the hard work of analysing traditional risk reports.

One way to mitigate hidden risks is to incorporate low-correlating assets into portfolios. Low-correlating assets exhibit a lower or non-existent correlation with traditional asset classes like stocks and bonds. By incorporating these assets, investors can achieve improved diversification and risk management, even when stocks and bonds move in tandem.

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