Risk, uncertainty and
the credit crisis – could
we have known better?
Presentation to PortfolioConstruction Conference 2008
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“Don’t
Don t worry,
it’s only mist”
Beijing Official
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Constancy
•
•
•
•
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Education
Ed
ti
and
d experience
i
Evidence and compulsion
The human paradox
p
The risk return trade off
2
Education
and
Experience
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Normal Distribution
-60
-55
-50
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-45
-40
-35
-30
-25
-20
-15
-10
-5
0
5
4
10
15
20
25
30
35
40
45
50
55
60
65
70
75
Mandelbrot’s Madness
• “Cl
“Clouds
d are nott spheres,
h
mountains
t i
are nott cones, coastlines
tli
are not circles, and bark is not smooth, nor does lightning
travel in a straight line”
• A few very big, many very small, not very
many medium sized movements
• But there are patterns – if price changes start
to cluster the have a tendency to do so for a
while and then unexpectedly they stop.
• Bubbles are inevitable
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5
Observations
• Dow
D
Jones
J
Industrial
I d t i l Average
A
from
f
1916 to
t 2003:
2003
• >3.4% movement in a day expected 58 times, but witnessed
1,001 times
• >7% expected once every 300,000 years, but we’ve seen 48
• Foreign exchange markets USD/ Yen
• 7.9% daily change, 10.7 times the standard deviation
• Between 1986 and 2003 – dollar fell substantially, but nearly
half that decline occurred on 10 (out of 4,695) days
• Market bust of 1987
• Collapse of the internet bubble late 90’s
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6
Australian Observations
Credit
Crisis
8 000
8,000
BS
ASX/ S&P 200
7,000
6,000
October
1997
5,000
WTC
Bali
4,000
3,000
2,000
4,109 days = 43 x 3δ events
1,000
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7
20008
20007
20006
20005
20004
20003
20002
20001
20000
19999
19998
19997
19996
19995
19994
19993
19992
-
Australian Observations
12.0
ASX/ S&P 200
9.0
60
6.0
3.0
-3.0
-6.0
90
-9.0
2007 to date = 27 x 3δ events
-12.0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
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8
Australian Observations
12.0
Bond market
9.0
60
6.0
3.0
-3.0
-6.0
-99.00
1994 to
t 1996 = 54 x 3δ events
t
-12.0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
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9
Evidence
and
Compulsion
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A Prudent (but elusive) Equilibrium
Risk
under priced
Reckless
Risk Taking
Risk
over priced
Prudence
increasing
regulation
laissez-faire
regulation
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Frightened
Risk Aversion
11
Financial Instability is Inherent
Market
Status
Instability
Stability
Investor
Behaviour
Frenzy
Optimisation
Conservative
Marginal debt
unit
‘Ponzi’
‘Speculation’
‘Hedge’
Balance sheet
effects
Income< interest
coverage, borrow
(or sell assets) to
pay interest
Asset income =
interest payments
Asset income =
interest payments and
loan principal
amortization
Risk
Spectrum
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Risk taking
Risk averse
12
Risk Aversion, Sentiment, Madness
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13
The
Human
Paradox
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Misbehaviour of the Human Psyche
• Examples of iteration and their corrosive
influence
• Miss market trends
• Intuit market trends where none exist
• Price departures from fundamentals
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15
Mainstream Tested
Products
Capital stable
Balanced Funds
Passive Management
Mid 2000's
Multi manager
Hedge funds
Early
2000's
Infrastructure
Portfolio Protection
IT funds
Emerging Markets
Exotic Credit
Investments
90's
2002
Uptake
Abandon
bear markets
disinflation
rangebound markets
low conviction
bull markets
bull markets
inflation
trending markets
high conviction
bear markets
Late
2000's
inefficient markets
p
y
low transparancy
high volatility, low return, net inflow
environments
PPP all the rage
bear markets
new wave
low volatility
low risk aversion
increasing regulation
16
efficient markets
g transparency
p
y
high
during or after crisis
PPP debacle
bull markets
00's
2007
crashes to shore
high volatility
heightened risk aversion
increasing scrutiny
The Allure of Growth
• Money is cheap and available
• Superannuation fund flows
• Cost of debt
• The corrosive power of success
• Asymmetry of returns
• Boom mentality
• Diminishing view of risk
• Erosion of due diligence
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17
Destruction of Conviction
• The internet will drive revolutionise the
market
• The commodity boom will ride on the
tail of the Chinese dragon
• Evolution of property management
benefits shareholders
• Central banks are more experienced
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18
Normality, Myopia and Amnesia
• $AUD at parity
• Oil at $200 a barrel
• Trading range of ASX 4300-5000?
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19
The
Risk/ Return
Trade-off
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Fixed Interest Evolution
R t
Return
Broad Market
Extended Market
Emerging Opportunities
Government
High Yield
Structured Products
IG Credit
ABS, Mortgages
Hybrids
Synthetic Securities
EMD
Ri k
Risk
Practical
Consequence
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Mathematical
Process
21
Risk and Intention
1,600
,
1,400
AU$ billion
1,200
Non-Government
1,000
Government
800
600
400
200
Probability of Loss
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Absolute Volatility
22
Relative Volatility
Sep-07
Sep-06
Sep-05
Sep-04
Sep-03
Sep-02
Sep-01
Sep-00
Sep-99
Sep-98
Sep-97
Sep-96
Sep-95
Sep-94
Sep-93
Sep-92
-
αβδετθλ
Fixed Interest
• The Noise
• “Australia Rides Commodity Boom Wave”
• “Shares Set to Rise”
• “Wall Street Back on High“
• The Environment
• Global financial system awash with liquidity
• Consumer confidence (and spending) healthy
• Long
L
term
t
yields
i ld att hi
historic
t i llows
• The Decision
• Extrapolate, speculate, sit on the fence
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23
Fixed Interest
• The
Th Outcome
O
18
16
2 year (% pa)
14
1 yr (%)
Frequencyy
12
UBS Composite
10
(both periods)
8
6
4
2
Performance (%, annualised)
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.0
.0
11
10
9.0
8.0
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
.0
-1
.0
-2
.0
-3
.0
-4
.0
-5
.0
-6
.0
-7
.0
-8
.0
-9
0.0
-1
-1
1.0
0
Fixed Interest
• The
Th Outcome
O
– risk
i k di
dispersion
i
6.0
Median Risk
5.0
Return
n
4.0
3.0
Median Return
2.0
1.0
00
0.0
0.5
1.0
1.5
2.0
2.5
Risk
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25
3.0
3.5
4.0
Active Management
• Role
• Objective
• Facility
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26
Conclusion
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Let’s start thinking about…
This session was:
1. awful
2. mediocre
3 good
3.
4. excellent
Gizmos brought to you by
Let’s start thinking about…
Time’s Up!
This session was:
1. awful
2. mediocre
3 good
3.
4. excellent
Gizmos brought to you by