Better Risk Management

Abstract

In this article the author shows how a single criterion, the maximization of expected compound return of discretionary wealth, can be used to improve risk management practices in a wide variety of applications. Applications include setting appropriate short–term risk tolerance, evaluating the impact of skewed and fat–tailed return distributions, and analyzing stop loss orders and portfolio insurance – as well as better management of active managers. The author shows the impact of the failure of tracking error to account for the covariance between active policies and benchmark risk as well as the potential for deceptive information ratios. Finally, he shows how to convert momentum and value investor styles into option–equivalents that can then be assessed in terms of latent risk and impact on expected compound return. It becomes obvious that value investing is like selling a put and a call.

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