Risk Quotes

I'll not even try to give a definition of 'Risk Management'.
More than the word Risk, Risk Management is full of traps and paradoxes.

Just to mention some.....

Risk Management is...

• not primarily about risk that can be calculated with a 99,x% confidence level
• dealing with Risks you know will come, but can't be calculated
• more about correlation in time than mean estimates and standard deviation
• more about prevention, foreseeing and managing risk than capitalisation of risk
• more about taking risks to benefit, than trying to exclude risks
• fighting risk instead of excluding risk
• making Plans B and C, in case your confidence level fails

Avoiding Risk

One of the trickiest parts of Risk Management is that we often  are trying to avoid Risk at any price.

By doing so, we introduce a new risk: It gets harder to achieve shareholder and client value.

Often returns will decline because of over-capitalisation and a risk-return unbalance.

Finally we have to compete in new risk areas we're not experienced in. 

It's all well expressed in a cartoon on cartoonstock:

'We've considered every potential risk, except the risks of avoiding all risks.'


Personally I prefer the challenging Risk Management quote of Jos Berkemeijer, that states:

 "Risk Management: the art of foreseeing hindsight."

Better than trying to define Risk or Risk Management, it is to study and get inspired by Risk Quotes.

Therefore I conclude this Blog with a link to the Blog 'Risk Quotes'

You can place a random quote like this one:

Random Risk Quote

on your website or Blog by copying the next javascript code.

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Install Instructions

1. Copy above JavaScript code (select;CTRL-C).
2. Paste (CTRL-V) the code on your webpage or Blog
   Blogger: Go to Design Tab, Click on Add a gadget;
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Related Links
- Risk Quotes
- Riskviews: quotes
- Best Risk Management Quotes
- Death of Risk Management

Actuary beats Chimp (or not?)

Is your joy for stats just as big as Hans Rosling's enthusiasm shows?

Just watch how Hans tells the developing story of Lifespan against Income in more than 200 years, showing around 200 countries in a 120.000 numbers flowing chart!



It's clear, we actuaries can learn from Hans with his (1) 'sticky enthusiasm' and (2) 'keeping the issue on headlines'.....


You can play for your own with the data Hans uses on Gapminder World

No doubt..., your next board presentation will be dynamic and flowing.

To conclude... If you as an actuary think you know more about the actuarial world than a chimp, please take Hans Rosling's

Beat the Chimp test

on facebook.


Let's hope for the 'best'.....

Related links:
- Gapminder World

Fun: Actuarial Dasboard Crash

Last week I gave a Risk Management training about pension funds. After illustrating several times the importance of adequate risk management dashboards, one of the attendees suddenly stated:

'No matter how impressive your dashboard, you should keep your eyes on the road!'........

Right he was! A driver  who's constantly focused on his dashboard will sooner or later end up in the bush and finally crash.

We, actuaries and risk managers all trust on our dashboards, but at the same time we should keep our eyes open to anticipate on coming events in a changing marketplace.

Sometimes it's even better to just leave the road, as the next video shows...


Police Risk management

David | Myspace Video

Anyhow, keep your eyes open, to prevent an Actuarial Dashboard Crash.....

Related Links:
- Alfa Romeo Spider Veloce: Don’t Let Dashboards Drive You Crazy

Stress test stress test

How did you interpret the title of this Blog......? 

Can you read it in more than one way? In how many ways can you read it?

Still confused?

Enough questions to start this blog.

In short: the more ways you are able to read this title, the more successful you'll probably be in defining and executing 'Stress Tests" in practice.

Let's dive a little deeper to illustrate this important 'multi interpretation talent' you need, to make stress testing a success.

Although there are far more ways (please add some interesting suggestions as comments to this blog) to interpret the title 'stress test stress test', we'll analyze in this blog two interesting  interpretations that follow from the fact that 'stress test' can be interpreted as a noun or as a verb.

1. stress test [noun] stress test [noun]

Interpreting the title as two nouns could:

• make you aware of the importance of stress tests
• emphasize the importance of repetitive execution of stress tests
• illustrate the feeling of disinterest and apathy that occur when important words are repeated to often without enough plowing depth..
  
  

2. stress test [verb] stress test [noun]

This perhaps the most interesting interpretation.
How can you really stress test your stress test?  

The way we stress test at financial institutions like banks, insurance companies and pension funds, is basically more or less as follows:

• Project historical crisis crash-data into the future. Simulate what would happen and take a look at the consequences
  
  
• Test crash scenarios on basis of the question: What would happen if.... (prices go down, S&P 500 collapses, etc., etc.)
  
  
• Take several economic scenarios. Project them on your balance sheet and see what happens.

To stress-test a stress test we have to develop a different view on stress tests.

A view based on the answer of the next leading question:

How many sides has a coin?

Let's demonstrate this new crucial view on a stress test.

A Different View on Stress Tests
Some examples:

• Inverted Stress Test
  An interesting way of stress testing is 'working the other way around': Try to define financial situations where you never want to end up in (e.g. equity< -5%, etc.) and try to imagine scenarios that could lead to this unwanted financial situation  Paul Duijsens, ALM Principal Mercer Investment Consulting, mentions this approach).
   
• Idiot Proof Stress Test
   Andrea Enria, chairman of Europe’s new banking regulator stated recently:
  
  A stress test is only as good as the scenarios you plug into it
  
  Therefore, make stress tests 'idiot proof' as much as possible.
  Once a stress test is developed, don't present it to the board directly. Organize a 'second opinion' from a professional company that's undependable and critical enough to seriously test and analyze your stress test and its assumptions.
  
  Presenting a stress test without clear statements about the limits, vulnerabilities, constraints and shortcomings (every test has shortcomings) is like playing with fire and  offering your board 'the wrong end of the stick'.
  
  So we can add another conclusion quote:
  
  A good stress test transparently presents its weaknesses
  
  If nobody can find a weak spot spot in your stress test: ask a 5 year old child to ask some simple questions.....
  
  
• Compare Stress Tests
  Please  think about :
  
  'One stress test' = 'No stress test'
  
  Comparing successively executed stress tests on assumptions, methods and outcomes is essential for a correct understanding of the impact and consequences.
  
  Not only compare tests of your own company, compare also with tests of other financial institutions. Questions like: why do we as a [pension fund]  have different assumptions and methods than an international [bank], are key to a correct understanding of your own risks.
  
  
• Surpass Regulator Constructed Stress Tests
  Regulator Constructed Stress Tests(RCS-tests) seem relatively easy to implement.
  As a risk manager or board member you don't have to think about scenarios or methods. That's all been taken care of by the Regulator. Easy, isn't it?......... Wrong!
  
  Heedlessly implementing RCS-tests is risky. First of all, the regulator's principles are partly biased. As an example, take the risk of treasury bonds on your balance sheet.  Treasury bonds are commonly seen (and valued) as save (AAA-rating). However, some countries (Greece, Spain,Ireland etc.) have already been downgraded. Which countries will follow? Does the RCS-test includes this non-hypothetical risk? No? Does your own test includes this risk?
  

• By definition regulators have to act and communicate in a responsible and 'prudent' way about government financial issues. If they wouldn't, world wide financial chaos would be the inevitable result.
  
  
  The other side of this 'prudent coin' is that the actual risks are probably larger than can be concluded from the government (treasury) interest rates and interest spreads in a particular country. Here you'll have to develop your own risk model or - if data fail - formulate  your own risk approach (get out!).
  
  Key is that, given the general level of  systemic risk, all financial institutions must be able to withstand haircuts on all their own sovereign debt holdings.
  
  A 'third side' of this coin is the fact that regulators (in time) might decrease risks on certain asset categories that are not in line with your own risk view. Stay awake to prevent from becoming 'Supervisory Stress Compliant'.........
  
  

• Unmask Derivatives
  Market valuation with respect to derivatives is tricky business and probably only valid as long as there's a 'normal' market activity. Nobody is able to value derivatives under severe market conditions as is the case in stress tests. So, depending on the size and characteristics of a stress test, don't hesitate to to unmask your derivatives by applying a large discount on the value of your derivatives.
  
  

Conclusion
Stress testing is not for dummies, but for professionals.
It turns out that the more you're able to look different, critical and 'out of the box', the more stress testing will be successful.

Making your audience aware that a coin has three sides instead of two, is probably the essence of an actuary's or risk manager's profession. 

It has become clear that analyzing assumptions, models, outcomes,constraints and shortcomings of a stress test is no superfluous luxury. So stress test your stress test!

Related links:
- KAS BANK develops stress test for UK pension funds
- Concerns over latest EU bank stress tests
- EU bank stress tests, a joke (2011) 
- Lateral Thinking:  US Economy Stress test (2011)
- World Wide Interest Spread by Country (2011) 
- Government Bonds yields 10 Year Notes 
- How many sides has a coin? 
- Worst-Case Scenario Survival Card Game 

Zero Problems Risk Management

More and more we actuaries and risk managers become aware that our risk models can't just be based on numbers and statistics exclusively.

Some examples:

Systemic risk

The recent financial crisis made it clear that a 'mono risk approach' on a sole risk-object (mortgage, fund-investment) is insufficient.

Investments and loans are embedded in a worldwide sea of connected financial instruments and reinvestments. Systemic risk has to be included in our models.

Main challenge here is that systematic risk essentially depends on macroeconomic and (mostly) irrational factors. Further, systemic risk is related to the structure and dynamics of the market. More than numbers.....

Supervisory Herding Risk

In their effort to control and support financial institutions like banks, pension funds and insurance companies, country supervisors, regulators and 'accounting standards boards', defined a meticulously set of guidance rules (Basel I/II/II, Solvency I/II, Qis-I-V, IFRS, FAS, AIFMD, FTK, FIRM, etc.,etc.)

Financial institutions not only confirmed and adopted to those new rules, but - in their rush and driven by cost and time pressure - also implicitly (and often unintentionally) declared those same imposed rules and rationales as their own business 'Risk Appetite'. This way, most financial Institutions became so called: 'Supervisory Compliant'.

Instead of  expliciting their specific company-targets and successively developing their own correspondent risk appetite and risk framework, they incorporated the supervisor's risk philosophy. 

Without a sound own (board) risk vision that would undoubtedly have included some extra safety on 'company specific risk issues', financial institutions became - like a herd - all in the same way extremely vulnerable to (less defined) external risks.

Summarized:

Overregulation increases Herding Risk

Financial institutions all measure and respond to regulated risks in the same way. Supervisory Herding Risk is born.....

Too Much Focus Risk

As a consequence of pre-subscribed risk categories and ruling by law or (accounting) standards, there's the risk of 'too much focus' on specific risks while forgetting, denying or neglecting other important risks. Remember, the devil is in the (correlating) details....

Here's a useful, but not exhaustive, checklist to keep track on your risk models...

Average Premium Risk	Diversification Risk	Matching Risk
Commodity risk	Employer Continuity Risk	Operational risk
Compliance Risk	Environmental Risk	Outsourcing Risk
Compliance Risk	Equity Risk	Oversight Risk
Concentration Risk	Herding Risk	Price Inflation Risk
Counterparty Risk	Interest rate risk	Property Derivatives Risk
Coverage Ratio Risk	IT Risk	Reinsurance Risk
Credit Risk	Legal risk	Reinvestment risk
Culture Risk	Legislative Risk	Reputation risk
Currency Risk	Liability Risk	Sex Calculation risk
Default Risk	Liquidity risk	Strategic risk
Deflation risk	Longevity Risk	System Risk
Disaster Risk	Market Risk	Systemic Risk
Discount Risk	Matching Risk	Wage Cost Inflation Risk

ALM Simplifying Risk

Univariate models are killing and even multivariate models have proven to be too vulnerable and too limited in the recent crisis. It's not just about correlation and covariance matrices. What we need is an self-explaining model. A model  that predicts or generates expected values in an economic context, depending on exogenous economic variables like inflation rate, GDP-Level, etc. and that is based on the same structured historical economic data-set.

We need 'Asset Liability Modeling New Style' and not only Stress Testing or
advanced and excellent Crash Modelling as well explained by EMB.

Geopolitical Risk

With Europe and Japan as recent examples, it's clear that risks come from everywhere around the world.

The consequence of earthquakes (Japan, Australia), a possible  country default (Ireland, Greece, Portugal, ..), political instability (Libya, Ivory Coast, ..), war threat (Vietnam,Iraq, ..), financial easing (US, Europe,...), on our economic system, prices and financial institutions seems substantial and - moreover- predictable.

More than just trying to catch and capitalize these kind of risks in our risk models, we need to develop (financial) mechanisms and products that can cope as best as possible with these kind of risks.

The Riskmap 2011, Managing Risk | Maximising Opportunity, offers a good description of the actual risks that influence our lives and risk models.

A nice example is the recent (unexpected) leading role that France took in action against Libya.  'Riskmap 2011' mentions the 'Arabic Poll 2010' that clearly shows (despite the lack of sympathy for president Sarkozy) the trust and sympathy for France. France clearly outperforms the US and president Obama  unfortunately has lost the trust of the Arabic world... Take a look at the next slide summary (or the original complete pdf):  

Arab Public Opinion Poll 2010 Summary

Arab Public Opinion Poll 20... by Jos Berkemeijer

The Arabic poll shows that the prime minister of Turkey, Erdogan, has clearly gained  the confidence and trust of the  Arabic countries. With Ergodan, Turkey - at the cross road between East and West - takes a leading role in the 'World Risk Management Process'.  Ergodan's Risk Philosophy, invented  by the Turkish Foreign Minister Ahmet Davutoglu,   is 'Zero Problems'.....

Perhaps that should be the philosophy of actuaries too...

Zero Problems

Conclusion

From now on 'Modeling Risk' is more than just a financial exercise.
It's building scenario's, mechanisms and products that can cope with this risky world.  Success as actuary or risk manager!

Related Links:

- Committee (behaviour) assessment tool
- Control Risks:Riskmap 2011
- Arabic Poll 2010
- Supervisory Compliant
- Maplecroft Risk Maps 
- EMB: How to Model a Crash (REVO) 

Fukushima Risk Management

With all due respect for the Japanese risk managers, engineers and the Japanese people in general: The latest 2011 M=8.9 Earthquake in Japan made clear that the current Risk Models, as well as Risk Management itself, have tragically failed.

Shortcomings
Shortcomings in headlines:

• Underestimation of the probability of a M=8.9 (M>8) event
• Risk Modeling mainly focused on 'direct' earthquake effects
• Underestimation of cumulative correlated devastating effects that occurred as a consequence of a combination of Earthquakes, Tsunamis, Nuclear Disasters and Physical Concentration (4 reactors in a row!).
  
  

Frequency?
It's true, the worldwide annual frequency of a serious earthquake with a magnitude of 8 or more (M>8) seems small....

Yet - no matter how low the probability- the consequences (loss) is unacceptable if the damage in case of an event (like an earthquake M>8) is not manageable, exceeds a country's financial recuperation power, or devastates thousands of lives...

End of Time?

Lots of worrywarts think the end of time has come, as severe earthquakes are increasing.

Simple statistics show that this is not (yet ?) the case:

The expected average Magnitude value of all earthquakes with M>=7 over the period 1950-2011 (March) is M_a=7.6 with a standard deviation of SD= 0.4. The average value of the last 10 years turns out M_a=7.4 with the same SD (0.4).

Nevertheless, when we examine the graphic more closely, there seems a light (significant?) increase in large magnitude earthquakes in recent decades.....


Back to the year 0
For what it's worth, the average magnitude for M>=7 earthquakes over a longer period from 0 to 2011 (March) , turns out in line with M_a=7.6 and a SD=0.44. Or in graphics:

History Earthquakes in GoogeMaps
Finally, take a look at the history of all earthquakes with a magnitude of 7 or higher on GoogleMaps... (take look at your country!)


Earthquakes, Magnitude> 7, years 0-2011 weergeven op een grotere kaart

Let's hope and pray for the Japanese people that that the brave engineers who are fighting the current meltdown at Fukushima will succeed and survive.....

Related links
- Spreadsheet (Excel) Earthquakes 0-2011 (March), M>=7
- Crash Course Earthquake calculation by Professor Nicholas Pinter
- Effect of Seismic Risk Measures on Japanese Housing Prices
- Earthquake Software
- Download Earthquake data from USGS
- Earthquake Safety of Nuclear Power Plants
- PPT:Japan’s Nuclear Energy Program(2003-2004)
- Design criteria Japanes Nuclear Plants  
- Prediction of ground motion
- Seismic Risk Evaluation (2004)
- Earthquake Facts 
- Earthquake FAQS 
- GeoBatch: Earthquakes (history M>=7)
- GoogleMaps: Earthquakes (history M>=7)

Groupthink

IMF evaluated its role and performance in the recent financial and economic crisis.

Cause

In a 2011 crisis report with the short title: 'IMF Performance in the Run-Up to the Financial and Economic Crisis:IMF Surveillance in 2004–07 ', IMF concludes that the main cause of their inadequate response during the crisis was:

Groupthink

IMF’s ability to detect important vulnerabilities and risks and alert the membership, was undermined by a complex interaction of factors, many of which had been flagged before but had not been fully addressed.

The IMF’s ability to correctly identify the escalating risks was hindered by:

1. A high degree of groupthink 
2. Intellectual capture
3. A general mindset that a major financial crisis was unlikely
4. Inadequate analytical approaches
5. Weak internal governance
6. Lack of incentives to work across units and raise contrarian views
7. A review process that did not “connect the dots” or ensure follow-up
8. Some impact of 'political constraints'....

Recommendations

IMF suggests some recommendations on how to strengthen its ability to discern risks and vulnerabilities and to warn in the future. Main point is to enhance the effectiveness of surveillance: it is critical to clarify the roles and responsibilities of the Board, Management, and senior staff, and to establish a clear accountability framework.

Looking forward, IMF needs to

1. 
   Create an environment that encourages candor and considers dissenting views
    
2. Modify incentives to “speak truth to power”
    
3. Better integrate macroeconomic and financial sector issues
   
   
4. Overcome the silo mentality and insular culture; Deliver a clear, consistent message on the global outlook and risks.

Recognize Groupthink
Groupthink is not just something happening to IMF or 'other organisations'. We, financial institutions, all suffer somehow or somewhat from the Groupthink Virus.

How can we recognize Groupthink?
Derived from an article by Irving Janis, the inventor of the word Groupthink, let's take a look at some explicit signs of Groupthink:

1. Winning Mood syndrome
   A common illusion of success (Folie à deux), invulnerability, over-optimism, unanimity and risk-taking as a consequence.
2. Collective rationalization
   Managers, employees discount warnings and do not reconsider their assumptions
3. 
   Repression or Ridicule
   Direct pressure on and ridicule of  individuals who express disagreement with or doubt about the majority view or the view of the leader
4. Fear
   Fear of disapproval for deviating from the group consensus. Fear from or doubt about expressing your opinion.
5. Manipulating
   Remaining silent in a discussion is implicitly interpreted as agreeing.Obviously 'wrong' arguments are used to achieve a certain goal or policy.
6. Disrespect
   Stereotyped views of out-groups or enemy leaders as evil, weak or stupid. Good or serious ideas of colleagues are rejected on basis of the source instead of 'judged by the facts'.
7. Moral Blindness
   Unquestioned belief in the inherent morality of the in-group. Lack of discussion about ethical or moral aspects of certain decision.
8. Miscommunication and Misinformation
   Information, bottom up or top-down is (deliberately) strongly filtered
9. Idolization
   Idolization of the leader or of certain five star employees.

Lessons Learned
If you recognize some of the above signs in your organization, it is time for action.
Discuss it, do not accept it and if you cannot change it... LEAVE!

A humorous example of Misinformation are the quotes of Iraq's minister of (Mis)Informaton, Al-Sahaf, during the 2003 Iraq war.
Enjoy, laugh and learn.....



Make sure your board presentation is not based on' sahaf-statements' but on simple provable actuarial facts....

Related links/sources:
- 8 signs of groupthink
- What is Groupthink?
- IMF Crisis Report 2011

Actuary Bill Gates

For those of you that -just like me - didn't know that Bill Gates is actually a qualified actuary....



Bill Gates.., a man with a great vision and the same size of philanthropic heart. More information about Bill on the 'Bill and Mellinda Foundation' website, were another actuarial statement is launched:

All Lives Have Equal Value

With all due respect for Obama: Bill gates for president!

Links:
- 2010 Annual Letter from Bill Gates

Supervisory Compliant, is it enough?

Risk management is tricky business... Being 'Officially Compliant', 'Just Compliant' or in other words "Supervisory Compliant", is not enough to help your CEO survive with your company in the complex market battle!

Whether you're an Actuary or Risk Manager of an Insurance company, Bank or a Pension Fund, the risk of being 'Supervisory Compliant' is simply : bankruptcy!

Becoming 'Supervisory Compliant' in complex programs like Solvency-II, Basel III or Legal Pension Fund Risk Frameworks, consumes so much time and effort, that almost no time seems to be left for contemplating or doing the essential Risk Management work properly.

Just being 'Supervisory Compliant' implies:  constantly running after the Supervisor to become  'just in time' officially compliant and not having enough time to think about the (f)actual relevant risks.

Supervisory Compliance becomes very frighting when Risk Appetite and Valuations are rashly based upon the minimum Supervisory requirements, as is (e.g.) the case in the Dutch Pension Fund legal framework. Boards stop thinking about the actual risks and feel compliant and satisfied once the Supervisory Compliance Boxes are checked.

A new look at compliance
Let's take a look from a new point of view at the complete Risk Management Compliance Field:

In basis there are three types of 'being compliant':

1. Supervisory Compliant
   When you're Supervisory Compliant, you officially comply to all legal Risk Management compliance requirements. Your Supervisor is happy...
   
   
2. Professional Compliant
   You comply to your own professional Risk Management standards. You are happy...  but what about your Supervisor? Comply or Explain....
   
   
3. Success Compliant
   Being Success Compliant implies that all Risk Management requirements that are key to have success - e.g. key to survive in the market on the long run - are met.

Let's zoom in at some specific areas in this chart:

Bias areas

It's perhaps hard to admit, but in our attempt to be complete, we define and manage a lot of (small) risks that do actually exist, but are in fact not really or limited relevant with regard to company continuity.

Distinctive Character area

The Distinctive Character area is perhaps the most interesting area. To get grip on this area urges us to 'Think outside the Circle'.

By doing so we'll be able to manage risks that  our competitors fail to do. Here we can achieve 'Distinctive Character' by managing risks more efficient or by turning risks into profits. Examples are: Derivatives that limit our investment risks. Specialized experience rating (rate making) on your portfolio on basis of characteristic and unique risk profiles.

Tricky area
The tricky area is the area that consists of Supervisory Risks you tend not to find important, but that are very important for achieving success in the market. Tricky areas could e.g. be: Deflation Risk, Longevity Risk or Take Over Risk.

Reversed Thinking area
This is perhaps the most interesting risk area.

To explore this area you'll not only have  to 'think outside of your circle', but - just like in reversed stress tests with Banks - try to think backwards, to find out what could cause a certain event or loss.

This reversed thinking process succeeds best as a group. Group members should be professionals and non-professionals from different types of business, education and background.

A successful group mix could e.g. consist of : an actuary, an accountant, a manager, a marketing manager, a compliance officer, an employee, a client, a shareholder representative and last but not least the receptionist.

Finally.....
Try to find time to manage your company to new heights and stop being just 'Supervisory Compliant'.....

Gold: Risk or Rescue?

For those of you who are still doubting...we live in a crazy world....

The Dutch Central Bank (DNB) has ordered (by court !) the glass-workers pension fund (SPVG) to decrease its 13% Gold allocation to less than 3% within two months.

DNB and Court arguments in short:

1. An investment of 13% is not in line with the Prudent Person Rule, which includes the principle that: assets must be invested in such a manner as to ensure the security, quality, liquidity and profitability of the portfolio as a whole.
   
   
2. Gold is a commodity and holding 13%  is classified as 'overweight' in comparison to the 2.7% average that Dutch pension funds have invested in commodities.
   
   
3. 15% allocation in Gold is a 'concentration risk' that could lead to a coverage shortage if the gold price imploded (volatility of Gold is relatively large).

At first, it seems unbelievable that important decisions, with substantial financial impact  - even in Court - are not based on financial facts, but on 'general principles' and the way the market 'used to do it'.

A decision based on an argument that refers to 'the average pension fund,' would more or less imply that pension funds would not be allowed to base their investment strategy on their own specific situation or a changing market outlook. Pension Fund Boards appear to be  'captured' by the market and a Supervisor who obviously has a hard time to develop 'own standards'....

Secondly, DNB actually takes over the investment responsibility of the pension Board. One could wander if DNB is (sufficiently) aware of the possibility that it can be hold financially responsible for the effect of a negative outcome if it turns out in the near future that SPVG has suffered a substantial financial loss, caused by this DNB-designation.

Is Gold really a risk?....  or a rescue?

Checking the facts.... 
Let's just check if DNB's and Court's arguments are valid.....

Yearly Return
We start by comparing the yearly returns of Gold, the S&P-500 Index and '10-Y Treasury Bonds' over the period 1971-2010.

To make Bonds risk-comparable with Gold and the S&P-500 Index, the yearly average Bond interest rate is translated into a yearly Market Value performance. This is done by assuming that each year, all '10-Y Bonds' bought in a specific year are valued, and sold at the average interest rate one year later (approximation).


Here is the result:

To bring some sense and order into this chart, we calculate the 'Moving Compound Annual Growth Rate' (MCAGR).
We start in 2010 and calculate the  compound average yearly return backwards moving up (year by year) to 1971. This is the result:

Now, this looks better... and a bit surprising as well!!! On the long term Gold (μ=9.2%) and the S&P-500 (μ=10.2%) are tending to a rough 9-10% yearly return......  A little bit Surprising is that Bonds (μ=7.6%) get along very well with their big risky brothers...
Take your time to 'absorb' the impact of this chart.....

Risk
Next, we take a look at Risk. We define Risk at first as the Standard Deviation (SD). We directly cut trough to the 'Moving Risk' (Moving SD).

We might conclude here that during recent years there was an increase of risk with regard to the S&P-500 (the 'red' crisis 'Mount K2' is clearly visible). Note that also for a longer period, i.c. the last 30 years, the S&P-500 Risk is substantial higher than the Risk of Gold and much higher than the Risk of Bonds. Only looking at a period of 40 years, Gold shows 'optical' up as more risky (SD=σ=25.8%) than the two other asset categories, Bonds (SD=σ=6.9%) and S&P-500 (SD=σ=18.1%).

However this way of presenting Risk is strongly discussable. Another view of Risk that comes closer to what we naturally 'perceive' as Risk, is to define Risk as only as the Downside Standard Deviation (look up : Sortino ratio ), where all positive yearly returns are eliminated (DSD) or set to zero (DSDZ).....
Let's have a look:

Now, these charts give us a quite a different sight on Risk-reality....
It shows that -on the long term -  not Gold (DSD=Dσ=7.5%) is the riskiest asset, but the S&P-500 (DSD=Dσ=10.6%). Bonds (DSD=Dσ=0.5%), as aspected, have the least volatility and are therefore less risky.

Perhaps the Risk of Bonds is a bit underestimated (very few observations) by the DSD-method (excluding positive yearly returns). In this case the downside deviation of yearly Bond-returns, replacing positive returns by zero, which generates a standard deviation of 3.2%, gives a better indication of a more likely standard deviation on the long run.


Why Gold? 
Although these simple calculations already put the DNB conclusions in a different light, let's get to the main point that should be addressed in defending why Gold should be a substantial part of any Pension Fund portfolio:
 

 Gold Reduces VaR

In a 2010 (october) publication the World Gold Council published a document called Gold: Hedging Against Tail Risk. This interesting report concludes:

1. Gold is first and foremost a consistent portfolio diversifier
2. Gold effectively helps to manage risk in a portfolio, not only by means of increasing risk-adjusted returns, but also by reducing expected losses incurred in extreme circumstances such tail-risk events (VaR).

Following this excellent WGC report, let's test the balancing and risk-reducing  power of Gold by analyzing (classical) Risk (SD) in combining Gold with different allocations (0% up to 100%)  in an asset mix with Bonds, respectively investments in S&P-500 stocks.

This chart clearly shows that Gold has the power to reduce the S&P-500 Risk (SD) from18.1% to 13,3% with an optimal asset location mix of  approximately 60% S&P-500 and 40% Gold. 

In case of Bonds the Risk (SD) is reduced from 6.9%  to 4.8% with an optimal mix of 80% Bonds and 20% Gold.

Asset Liability Model (ALM)
In practice it is necessary to optimize, by means of an adequate ALM study, the  allocation mix of stocks, Bonds and Gold. Just as a 'quick & dirty' excercise, let's take a look at the next asset-combination scenarios, based on data over the period 1971-2010:

Just some head line observations:

• From scenario M1 it becomes clear that even a 100% Bond scenario is't free from Risk. So diversification with other assets is a must.
  
• Looking at M2-M5 we find that the optimal mix, defined as the mix that best maximizes Return (Compound Annual Growth Rate)  and Sharpe Ratio (at a Risk free rate of 3% or 4%) and minimizes Risk (Standard deviation), is something something in the order of: 70% Bonds, 15% stock and 15% Gold.
  
• Scenarios M6-M8 and M9-M11 take todays most common (but strongly discussable!) practice as a starting point. Most pension funds have allocated around 50% or 40% to Bonds and 50% or 60% in more risky asset categories (stocks, etc.). It's clear that even in this situation Risk can be reduced and Return can be optimized, if Stocks are exchanged to Gold with a maximum allocation of 20% or 30%.

Notifier

Although this 'rule of thumb exercise' on this website provides some basic insights, please keep in mind that finding the optimal mix is work for professionals (actuaries).

A serious ALM Study is always necessary and should not only take into account a broad range of diversified asset categories, but should also focus and optimize on:

• The impact of the liabilities (duration) and coverage ratio volatility
• The Timing: Mean values and Standard Deviations are great, but the expected return highly depends on the actual moment of  investment or divestment in the market.
• Future expectations. In the current market situation (2011) the risk of interest rates going up and therefore Bond market value going strongly down, isn't hypothetical. Secondly, the stock market has been pumped up by trillions of 'investments' (?) in the US economy. Once this crisis-aid definitely stops, the question is if these 'cement investments' will be strong enough to keep stocks up. Personally I fear the worst...
  Not to mention a scenario with declining stock rates in combination with increasing interest rates and inflation......
  Who said the life of an actuary was easy???

Conclusion
We may conclude that:

• Investing in Gold up to a 10% to 15% allocation, reduces the Risk of a portfolio consisting of Bonds and S&P-500 Stocks substantially. 
• Gold is less Risky than investing in S&P-500 Stocks

Therefore the 'not with facts' underpinned intervention of DNB looks - to put it euphemistically -  at least strongly discussable....

A wise and modest underpinned allocation of Gold is no Risk, it's a Rescue!

Related Links:
- Spreadsheet with Data used in this Blog
- Prudent person Rule
- IPE: Dutch regulator orders pension scheme to dump gold
- GOLD: HEDGING AGAINST TAIL RISK
- Downside Risk:Sortino ratio
- Dutch Central Bank Orders Pension Fund To Sell Its Gold
- Pension Fund Benchmarking 
- Strategic Risk Managment and Risk Monitoring for Pension Funds

Bonus: Gold, Hedging against Tail Risk Video

Pension Fund Weigh House

Investment Benchmarking of Pension Funds has been made extremely difficult.

Just ask your Pension Fund's actuary whether your Pension Fund has achieved a 'market conform investment performance'... For sure you'll get a dazzling multiform and relative answer. It's all about 'market indexes' (stock and bond indexes), risk appetites, asset mixes, derivatives, uncertainty and lots of other interesting complex stuff that underpins the fact that the final answer to this simple question is nuanced, complex and relative.

A simple question
Ahead of all this growing complexity and 'levels of detail', a first key question has to be answered by every Pension Fund:

Was it worth setting up a complex multi fund investment plan instead of simply investing in 10-Years Government (Treasury) Bonds over an arbitrary period of (at least) the last 10 years?


Even this simple question, will probably not lead to a simply answer from your fund's investment manager or actuary.

Pension Fund Weigh House Help
This is where the help of the 'Pension Fund Weigh House' comes in...

Just look up the yearly return over the last ten years in your Pension Fund's annual report. Next, do the test at 'Pension Fund Weigh House'  (PFWH) and see for yourself whether your Pension Fund has  performed better than the simple benchmark: 10-Y Bonds.

 

Did your Pension Fund perform better than Bonds? (the compound mean over the last 10 years) Congratulations!
Was it worth the risk? Well..., just look at the Risk (Standard Deviation) or - even better - the Sharpe Ratio at different levels of possible 'Risk Free Rates' to find out. The Higher the Sharpe Ratio, the more it was worth to take the risk.

Market Value

To compare Bonds 'fair' with Market Value based Pension Fund performance, the yearly Bond interest rate is translated into a yearly Market Value performance. This is done by assuming that each year, all '10-Y Bonds' bought in January of a specific year are valued, and sold at the interest rate one year later.

Do it yourself

The standard example as presented on PFWH concerns the performance of the Dutch pension fund ABP, the third largest pension fund of the world. Answer the key question 'Was it worth?' for ABP for yourself.

ABP (Pfd-R) Performance 2001-2010

 

Go to PFWH and change the numbers and 'heads' in the application to fit the numbers of your own (pension) fund or change both columns (Bonds & PFD-R) to compare two pension funds .
Compare your pension fund to either  '10-Y Euro Government Bonds', '10-Y US Treasury Bonds' or the 'S&P 500 Index'.

From now on you may answer this extremely difficult question "How did my pension fund perform?" yourself in a  5 minute weigh house test.

Have (professional) fun!