How financial models define ‘market’ could be at the heart of how we define and understand risk. One is connected to the other. This is an idea of extreme importance for a society that not only gives undue weightage to financial risk but also relies on the return and growth that accompanies calculated risk-taking.
Though financial models have limited history, risk has traditionally been under-judged and might never be completely understood. We can’t pinpoint the source of the problem because markets evolve and what seemed risky yesterday is not that relevant today. Risk, like many other social parameters, is a moving target. Many risk parameters have moved from reverence to irreverence, as they failed to pass the test of time.
The bigger issue is how financial models understand and define ‘market’. Specialised or non-specialised, markets have been defined as a benchmark, an index. Around 50 years before, one could not expect Jack Treynor to really ask this question when he was working on the Capital Asset Pricing Model (relationship between risk and expected return), whether there was a need for redefining ‘market’ itself. There was less computing power. We did not even have futures or the 1980s’ risk management tools.
Decades passed and we never questioned whether our basic assumption of the market being a popular benchmark was correct. Behavioural finance was the first to challenge the status quo and break illusions built around beta and benchmarks. Framing errors were showcased among fund managers comparing their portfolio with benchmarks that showed enhanced performance. Then, of course, we had research suggesting the beta (relative performance) was dead. Researchers were still attacking the risk measure, not questioning the definition of market.
In a society integrating at a hectic pace, making universal collage films (Ridley Scott’s Life in a Day), rewarding companies for tying up the world in a social network, why is our market beta connected to a local index? Why is ‘market’ for us not a mix of assets, a group of traded financial assets? Beta looks for sensitivity of an asset compared to the index, but is the index not part of a group of assets? Is the index itself not playing multiple roles of performance, under-performance and neutrality in a group of assets? How does the risk measure account for the changing sensitivity of the popular benchmark? Is the real market not a group of assets made of a few thousand assets?
If an equity investor’s portfolio group also had gold, won’t he understand more about the performance of his equity portfolio in 10 years? Won’t expanding the definition of market from a blue-chip composite index to a large broad group with cross-assets break the investor’s illusion of gain and risk? Won’t it give a more balanced approach to measuring how much more alpha (risk-adjusted return) was possible? Won’t it help him see correlation in a different light? Won’t this redefined market help us to a better risk measure?
The author is CMT and co-founder, Orpheus CAPITALS, a global alternative research firm