Nobel Prize-winning economist Myron Scholes says changing how investors look at risk can improve the way it is managed, and can help boost returns.
He told the Fiduciary Investors Symposium at Stanford University that the focus of asset owners needs to shift from thinking of risk as a constant to considering how risks are changing. Then, the two important things in investment that would have to be included are time and risks changing.
“Most of what we’ve done in the past is concentrate on cash flows and trying to estimate cash flows. In my view, we also have to think about how discount rates change,” Scholes said.
“How the discount rates change affects our portfolios, and risk is really discount rates and thinking about how they change over time.”
The discount rate is low during times when risks are low, and when when risks are high, the discount rate is high. So the important part is really the phase transition, or how we get from low to high and high to low.
“It’s really trying to understand how to get information when risks are changing, not just the level of risk. And then if we concentrate on risks changing, we can then increase our return,” Scholes said.
For example, if asset owners know that risks are going to increase in the future, they would want to reduce their risk and have more powder dry, than when risk goes the other way. So they can reallocate.
“Even if you’re in a long run horizon, phase transitions are very important in risk. And what the data shows is that’s what we should be looking at. Not necessarily the level of risk today, but how it is changing. How to get information about changing risk to enhance our rates of return.”
Time Value
Scholes says asset owners typically think of risk management in four different ways.
One is the idea of holding inventory, so deciding on what risk to hold. That could be in the form of either a strategic allocation, or even tactical tilts such as more equities, less bonds and vice versa. Another way is turning over inventory to make money or generating alpha, whether through short term plays or by thinking about themes. But that is quite difficult.
The third way is to look at what the constraints of others are, and when they’re willing to transfer risk and pay people to take their risks, or periods such as liquidity crises when people want to liquidate portfolios quickly and dramatically.
“Because the risk changed, the price changed, the risk premium changed, the required rates of return changed, and you can make money by stepping in,” he says.
The fourth way to manage risk is to smooth the discount rate over forward in time, such as when you’re a long horizon equity holder, have no interim cash flows to worry about, and can hold for a very long time. Basically, a buy and hold strategy, or the strategy behind passive investments.
“The problem with that is it doesn’t take account of time. And the interesting thing in time is that even though it averages out, the volatility hurts you because compound return is what we should be interested in,” Scholes said.
Risk has multiple dimensions that we have to consider, so every period counts, and that is an advantage, because in compound return, everything multiplies.
“As every period matters, then we have to think about how to get information, not about what’s going to happen five years or three years from now, what’s going to happen next quarter or the quarter after that, if we’re managing money.”
