Wednesday, July 14, 2010

Relative Status in Practice

Some may note that 'relative status' seems rather far-fetched to their daily lives, but it is equivalent with 'benchmarking', which is endemic in investing. If all the professionals are benchmarking, you get the same result.

for instance, take British Petroleum (BP). Their stock's implied volatility spiked up to 100%, well above its peers in the energy sector (around 25%). You might think, taking some of your exposure to BP would be prudent. Yet as BP represents $79B in market cap, if you are investing in the energy sector, having zero shares of BP generates the same benchmark risk and doubling down and having twice as much capital in BP as in the sector benchmark. Risk to BP is merely deviating from the consensus, which in this case is its proportional market cap as a percent of the energy sector.

And then there's the decision to allocate to stocks vs. bonds, small cap vs. large cap, having cash vs. paying down your mortgage. All these allocations are relative to a benchmark portfolio, which is generally the average of what everyone else does.

In Kenneth Fisher's book The Only Three Questions that Count, in the references under "Risk" he merely has 'see benchmarking'. If everyone benchmarks, risk is deviating from the consensus, and thus taking too little exposure to any popular investment is just as risky as taking on a lot of exposure. Cremers and Petajisto have a paper where the define portfolio manager risk this way. If risk is defined as a deviation from the benchmark, it becomes like idiosyncratic risk, unnecessary, so unpriced. Further, via arbitrage 'benchmark risk' can not be priced, because you can't get a risk premium from both having zero or twice the normal exposure to BP.


FalkenFriend said...

What do you think of this paper suggesting high R^2 stocks underperform. High R^2 would seem to be similar to low idiosyncratic vol.

Anonymous said...

I'm interested in learning more about assessing investment risk, but this post didn't enlighten me. There are spelling and grammar errors in this post that cloud the author's meaning. Write more clearly, and find and editor/proofreader.