New Measures of Risk (and why markets are now very fragile)

Understanding risk is essential to successful investment management, yet most common measures, like beta, capture only risk within markets – disregarding systemic risk of the markets themselves.  Fortunately, new research is now shining light on “fragility” or systemic risk – how fast and how severely an unanticipated event will propagate through the markets. 

These studies were pioneered by Mark Kritzman, who recently shared a “Top Ten” list of the most systemically crucial companies and industries today. But before I channel David Letterman to relay those rankings, let’s review the theory behind this new research.

Though it may be futile to try to beat the market through security selection, Kritzman – the prominent quantitative manager, educator, and author who is currently managing director and chief investment officer of Windham Capital Management – nevertheless believes that the stock market, or any market taken as a whole, can be priced incorrectly.  In a recent issue of Financial Analysts Journal, Kritzman admonished readers to “respect the micro-efficiency of markets” but also to “Manage the macro-inefficiency of markets.”1

Kritzman has been researching how best to follow his second imperative for some time. In 2010, in the same journal, he published a paper on how to measure financial turbulence, which he defined as “a condition in which asset prices, given their historical patterns of behavior, behave in an uncharacteristic fashion, including extreme price moves, decoupling of correlated assets, and convergence of uncorrelated assets.”2 He noted there that in periods of financial turbulence, returns poorly compensate for risk, and that, although such periods arrive unexpectedly, they tend to persist.  His measure, he suggested, could be used to stress-test portfolios and to adjust their composition to make them more resistant to turbulence.

On Tuesday, December 20, Kritzman spoke to the Boston chapter of QWAFAFEW (Quantitative Work Alliance for Applied Finance, Education, and Wisdom) about his latest research, which examines the large-scale fragility of equity markets. The subject, complementary to his previous research, was systemic risk and the sensitivity of sectors, industries, and individual companies to that risk. His talk was a summary and update of a recently published paper of his. (At the outset, he acknowledged his collaborators, William B. Kinlaw and David Turkington, both of State Street Associates/State Street Global Markets.)

1. Mark Kritzman, “Post-Crisis Investment Management,” Financial Analysts Journal, January/February 2011, Vol. 67, No. 1:4-8.

2. Mark Kritzman and Yuanzhen Li, “Skulls, Financial Turbulence, and Risk Management,” Financial Analysts Journal, September/October 2010, Vol. 66, No. 5: 30-41.