A Better Way To Model Bubble Risk

Supreme Court Justice Potter Stewart famously punted when trying to define pornography, although he wryly admitted that “I know it when I see it.” The same might be said of financial bubbles. When The New Yorker asked Eugene Fama, a founding father of indexing, to comment on the so-called credit bubble that preceded the 2008 financial crisis, he refused to take the bait. “I don’t even know what a bubble means,” he said. “These words have become popular. I don’t think they have any meaning.” Perhaps, but that doesn’t stop anyone from trying to identify the danger signs in advance…

The Decline and Fall of Correlation

In the search for the holy grail of portfolio design – robust diversification – it’s tough to beat the classic stock-bond mix. If one side of this asset allocation dance is sliding (or rising), history shows that there’s a good chance the partner will be rising (falling). But is too much of a good thing a problem? The question comes to mind after reviewing a recent paper (“Positively Negative: Stock-Bond Correlation and Its Implications for Investors”), written earlier in the year by analysts at D.E. Shaw, one of the largest quantitative hedge fund managers. After decades of persistently low-but-moderately positive…

Modeling Risk: A Primer

At the core of modern finance theory is a simple but powerful idea: There’s a price tag for earning a higher return – higher risk. Defining risk is a slippery concept, although not for want of trying with an ever-lengthening list of quantitative metrics. But more choices don’t always lead to more clarity. If you ask ten different investors (or money managers) to explain investment risk, you could easily hear ten different answers. This is no trivial point since quantifying risk is essential for managing it, even if the best-laid plans for profiling risk have limits and don’t always unfold…

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