May 19, 2012

Risk Manager Test

Risk Manager is THE profession of the future.

For all (young) actuaries, econometricians and other talented whizzkids who are considering to become a Risk Manager, here's the ultimate test...

Find out if you really have more risk management talent than an average Duck Risk Manager.

Perhaps even some more experienced Risk Managers dare to risk their reputation by taking the test as well........ 

Risk Manager Test 
Imagine you're a risk manager during World War II...

Allied pilots are bombing targets in Germany. Most bomber airplanes come back with heavy damage, some even don't come back at all. Therefore it is considered important to protect bombers with extra armor.

As there is only very limited supply of retrofitting armor, you as a risk manager are hired to determine where this extra armor is best placed on a plane.

In order to find out the vulnerable parts of the plane, you mark every bullet hole of every plane that comes back from a bombing mission as a red dot on a plane-bullet-hole diagram.

After having observed more than 50 planes coming back, you end up with the next diagram:



Instruction
Please point out in detail the most important places where you as a risk manager, would put the armor on the plane.

READY?.......

To find Out if you passed the Risk Manager Qualification Test please press on the answer button.


ANSWER


Aftermath
The risk manager in this test actually exists. During WWII, the Hungarian-born mathematician Abraham Wald undertook a study with the British Air Ministry to use statistical analysis to help protect bombers flying over enemy territory. The data to be crunched included the number and location of bullet holes on returning aircraft, and the goal was to use this information to determine where to best add armor to the plane's structure.



Sources & Related Links
- Abraham Wald : original Report
- Abraham Wald's Work on Aircraft Survivability by Marc Mangel 
- The hole story: What you don't see will kill you 
- UK Bombers in WWII (pictures)

May 13, 2012

Strategy Outsourcing

Most Pension Fund Boards are sincerely convinced they define their strategy on basis of their own insights.....

In practice, the leading Investment Consultant - as trusted advisor - often has a strong influence on the board.

Very often the authority of the Investment Consultant is so dominant that it's "not done", permitted or 'seen as wise' to discuss the advice of the consultant. Nor is a second opinion seen as appropriate, as it might be regarded as a matter of distrust in the trusted advisor relationship.....

Unfortunately in these situations it is quite often the Investment Consultant, instead of the Pension Find Board, who implicitly defines the Strategic Plan, Risk Appetite and Asset Mix......

Of course this doesn't apply for YOUR Pension Fund....

In this case DON'T view or download the next power point presentation 'On how Strategic Advice got Outsourced'....
Strategy Outsourcing

Scroll through the presentation by pressing the right arrow button.

Confidence Fallacy
Last but not least: As most Investment Consultants advice more than one pension fund, it is not unlikely that a lot of pension funds get more or less the same kind of advice. This might give pension fund board members a false notion of confidence with regard to their (own) chosen investment strategy.

All the more reason to be extra vigilant that the chosen strategy is finally YOUR strategy and not that of your consultant......

Remember.....  Never Ever Outsource your Strategy!

Related Links 
- Download PDF: On how Strategic Advice got Outsourced
- Donald Duck Search Images 

May 8, 2012

Standard Deviation, a Poor Measure of Risk

As actuaries and/or risk managers we've been professionally brought up with some deep-rooted assumptions about what 'risk' is....

Difference between Science and Religion
One of my favorite statements is that there is no fundamental difference between a religion (believe) or science. Both depend on a number of axioms, the basic assumptions. Assumptions, we 'believe' or 'take for granted' on basis of our intuition and/or personal experience. Only by means of those axioms we're able to 'prove' other theorems in our system or model.

So what we have to conclude is that what we prove in our our statistical models, is as strong as the foundation (assumptions) on which our models are based.

Main problem is that the assumptions in our models are so trivial and often so frequently implicitly used, that we don't realize their impact. We've developed a blind spot.......


Risk Axioms

With regard to 'risk' I'll just discuss two of the most dangerous (risky ;-) ) assumptions on which most of our investment risk models are build:
  1. Risk = Standard Deviation (SD)
  2. Mean Reversion
    The theory that a given value will continue to return to an average value over time, despite fluctuations above and below the average value.


Explication
Risk is a much wider concept than just 'standard deviation'.
First of all there's an 'impact difference' between a downside risk and an upside risk. In general, what we perceive as risk is more in terms of downside risk. But yet..., we keep measuring and concluding  about risk on basis of 'standard deviation'.

Why SD Fails as a measure of risk
To illustrate the failure of Standard deviation (SD) as a measure of risk, take a look at the next example in which we compare the performance of two different asset classes, AC-I and AC-II, with the next characteristics:
  • AC-I and AC-II have the same average (compound) return of 2.5% per year
  • AC-I has a Standard Deviation of  13,9% and AC-II a SD of 27%
  • AC-I has a maximum deviation of minus 40.0% and AC-II of 76.3%



By definition AC-II is more risky than AC-I.....

However.., a two year old child will point out AC-I as far more risky than AC-II. First, downside deviations are  more risky than upside deviations and secondly, the 'incremental downside risk' of AC-II can be 'managed' much more effective than the 'crash downside risk' of AC-I.

Conclusion
The times of modeling risk on basis of Standard Deviation are over. We need more sophisticated models that describe and measure risk multidimensional and with respect to downside risk and not upward potential.

Let's conclude with a final question to test your 'stock crash insight'.

What was the worst performance of the S&P 500 and in which year?

Click on 'answer' to find out!


ANSWER

Read more about the S&P 500 performance on: S&P 500 Five Worst One Year Performances (in %)


Related Links
- Actuary-Info: Equity Returns and Mean Reversion (2010)
- Risk is more than standard deviation (2005)
- Our Monetary Blind Spot
- Black Ducks Comic Strips