The environment of heightened uncertainty lies in contrast with apparent investor complacency, as judged by current market pricing. While the current investment environment is one that features considerable uncertainty, valuations in equities and bond markets are high. This implies expected returns may be inadequate to compensate for the uncertainty in the environment. GIC’s investment response has been to build a resilient and diversified portfolio to ensure that capital and returns can be best protected over the long term.
Risk and uncertainty
Risk is fundamental to investing. Poorly managed, risk can lead to adverse investment outcomes that ultimately result in failure to achieve investment objectives. But in dealing with risk today, investors are confronted with profound questions. Statistical measures of volatility, the conventional definition of risk, are extraordinarily low by historical standards. And yet, global political, economic and social developments signify a highly uncertain, unpredictable future. How should investors measure and manage risk and uncertainty in this environment? How can they achieve their investment objectives in an age of uncertainty?
It was Frank Knight, an American economist, who made the distinction between risk and uncertainty. Knight defined risk as applying to situations where, while the outcome is unknown, the likelihood (or probability) of possible outcomes can be quantified through standard statistical computations such as averages, standard deviation (or volatility) and correlations. Uncertainty, on the other hand, as conceptualised by Knight, was drastically different from risk. For him, uncertainty applied to cases where the outcomes were unknowable. Correspondingly, their probabilities cannot be computed.
Knight’s distinction between risk and uncertainty is particularly germane for investors today. Recent history covers some notable market situations where the reliance on standard measures of risk has fallen short.
An example of the limitations of standard risk analysis was the Global Financial Crisis (GFC). During the run-up to the GFC, quantitative risk models were typically used to price complicated financial securities. While seemingly sophisticated, these mathematical models failed to capture important correlations, and possible changes in such correlations. The outcome was that risk was seriously mispriced, resulting in defaults and losses. For example, the Chief Financial Officer at a major investment bank said in August 2007 that the losses suffered on one of their hedge funds were “25-standard deviation moves, several days in a row” . Based on standard distributions of risk, such moves in prices should only have occurred about once every 13 billion years. The fact that such price moves were observed was a sign that the models of risk had grossly underestimated the true degree of risk and its price impact.
The current market environment features abundant liquidity and low yields, which have contributed to the suppression of volatility across equity markets (Figure 1). This does not mean that uncertainty has been removed from the environment.