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 To most of us in the financial sector, the events of 2008 were shocking. We have all struggled with the aftershocks and asked ourselves what happened and what led us there. Some have argued that this is an unprecedented situation, which may be true in terms of the speed and magnitude of the shock, and possibly the long-term impact on the real economy. But others see echoes of the past in terms of the elements that triggered the crisis and the way it has been unfolding.
In fact, history points to many precedents. Rogoff and Reinhart [2008] identified 18 major banking crises since World War II, and a casual count of recent crises shows a pattern of a major market event at least every 10 years. Most of the time, these crises have been linked to excess liquidity in the economy, combined with a general misjudgment on the benefits of a certain type of innovation. This time is no different. Excess savings from emerging markets were reinvested in developed financial and housing markets, while financial innovation in the form of sophisticated securitized instruments contributed to a false sense of security surrounding systemic risk reduction.
The experience of this last market shock highlights several shortcomings in the risk management and asset allocation practices that have been commonly adopted by industry practitioners. It is now clear that the underestimation of the frequency and magnitude of extreme events left many unprepared. In particular, the consequences of contagion on portfolios have been overlooked. By increasing correlation across asset classes, contagion significantly reduces the benefits of diversification in otherwise-well-diversified portfolios. In addition, liquidity dried up in many parts of the capital markets, leading to cash-flow issues for most investors, including many long-term investors such as endowments and pension funds. Finally, the intensity of the crisis exacerbated the negative consequences of nonmarket risks, such as counterparty risk, operational risk and concentration risk. This is vividly captured by Warren Buffett’s now-famous quote: “Only when the tide goes out do you discover who’s been swimming naked.”
In our view, the events of last year will force a number of changes in investment practices in the following areas:
- Management of Extreme Events: Business continuity planning (BCP) is a standard operational risk control practice for organizations, enabling critical processes to function in all conditions. Asset managers and plan sponsors need BCP plans for their portfolios. Achieving this will require methods to measure and model tail risk, rules to trigger BCP plans on predefined market conditions, and a consistent framework for stress-testing portfolios and planning for extreme event scenarios.
- Strategic Asset Allocation: Investors are rethinking asset allocation practices with a view to better managing downside risk and avoiding investment horizon mismatches, in particular for individual retirement products. They may more formally take into consideration cash-flow requirements and eventually move toward more risk-based allocations.
- Integrated Risk Management: There is wider recognition now that investors need an all-encompassing view of portfolio risk. They need tools that help them understand the sources of risk, not just the absolute levels. Breaking asset class silos will allow investors to view the sources of risk across all assets in the portfolio. New tools will be needed to look beyond market risk into other types of portfolio risks, such as counterparty risk, concentration and liquidity risk.
The rest of this paper addresses these three areas in more detail by looking at the main issues of last year’s crisis and possible solutions to mitigate their impact.
I. Managing Extreme Events
Extreme events can be characterized by volatility jumps, increased risk aversion, negative returns for risky assets, and increased correlation across asset classes. Such events actually happen more often than is commonly perceived. In just the last 21 years, we have experienced 10 major market events: Black Monday (1987), Gulf War (1990), European ERM Crisis (1992), Mexican Crisis (1994), Asian Crisis (1997), Long-Term Capital Management (LTCM) (1998), Tech Bubble Crisis (2000), September 11 (2001), Quant Crisis (2007) and Credit Crisis (2008).
Aside from the frequency of occurrence, it is also interesting to note the volatility spikes and clusters through time. Figure 1 shows the one-day losses in the MSCI World Index over a period of 20-plus years and reveals how market volatility can change drastically and unexpectedly in extreme events.
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