The Absolute Return Letter, April 2011: Confessions of an Investor

Monday, Apr 04 2011 by
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The Absolute Return Letter April 2011  Confessions of an Investor

“When models turn on, brains turn off.”

Til Schulman

I have been thinking a great deal about risk over the past couple of years. The depth of the financial crisis took many of us by surprise. I made mistakes. I am sure you made mistakes. In fact, the whole industry made mistakes, from which we should all learn. Whether we will is another story, but we should try.  Making those mistakes is all the more frustrating because I was aware of the dangers but, like most others, underestimated the magnitude. In fact I wrote about them – see for example the October 2007 Absolute Return Letter (Wagging the Fat Tail).

Now, let’s distinguish between trivial risk (say, the risk of the stock market going down 5% tomorrow) and real risk - the sort of risk that can wipe you out. The geeks call it tail risk, and James Montier provided an excellent definition of it in his recent paper, The Seven Immutable Laws of Investing, where he had the following to say:

“Risk is the permanent loss of capital, never a number. In essence, and regrettably, the obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.”

Following James’ line of thinking, let me provide a timely example of the complex nature of tail risk:

The Japanese disaster               

 Contrary to common belief, the disaster at the Fukushima Daiichi nuclear power plant was not a direct result of the 9.0 earthquake which hit Northeastern Japan on 11 March. In fact, all 16 reactors in the earthquake zone, including the six at the Fukushima plant, shut down within two minutes of the quake, as they were designed to do. But Fukushima is a relatively old nuclear facility – also known as second generation - which requires continuous power supply to provide cooling (the newer third generation reactors are designed with a self-cooling system which doesn’t require uninterrupted power).

When the quake devastated the area around Fukushima, and the primary power supply was cut off, the diesel generators took over as planned, and the cooling continued. But then came the tsunami. Around the Fukushima plant was a protection wall designed to withstand a 5.2…

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Disclaimer:  

This material has been prepared by Absolute Return Partners LLP ("ARP"). ARP is authorised and regulated by the Financial Services Authority. It is provided for information purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. Information and opinions presented in this material have been obtained or derived from sources believed by ARP to be reliable, but ARP makes no representation as to their accuracy or completeness. ARP accepts no liability for any loss arising from the use of this material. The results referred to in this document are not a guide to the future performance of ARP. The value of investments can go down as well as up and the implementation of the approach described does not guarantee positive performance. Any reference to potential asset allocation and potential returns do not represent and should not be interpreted as projections.


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About Niels Jensen

Niels Jensen

Niels Clemen Jensen has nearly 30 years of investment banking and investment management experience. He began his career in Copenhagen in 1984 before moving to Sherson Lehman in London in 1986. In 1989 he joined Goldman Sachs and became co-head of its U.S. equity business in Europe in 1992, a post he held until 1996, when he joined Oppenheimer to manage its European business. In 1999 he re-joined Lehman Brothers, now in charge of European Wealth Management. In 2006 he was appointed Director of Trafalgar House Trustees Limited, advising one of the UK's leading corporate pension funds on its investment strategy. Niels founded Absolute Return Partners in 2002 and is its Managing Partner. He is a graduate of University of Copenhagen with a Masters Degree in economics. more »


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