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Current methods of assessing market and portfolio risk focus on short-term risk and cannot account for long-term dynamics of market risk and personal risk. This paper uses additional factors to extend current methods for long-term risks.


Managing Material Risk

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Overview

The current methods used to assess market and portfolio risk extend back to the early 1990s. These methods were developed for banks and broker/dealers and then were adopted by the portfolio management and hedge fund community. This audience focuses on short-term risk, which is measured in days for the broker/dealer’s blotter and in months for hedge funds and investment managers. The current methods fail to reflect the dynamics that become increasingly important over the long term—dynamics that generate the periods of major downturns and instability that can derail lifestyle goals and even threaten basic financial security. These are the material risks for individuals and other asset owners. Unlike a bank or portfolio manager, risk comes at an individual from two directions: (1) the market risk that directly affects individual wealth and (2) the personal risk that comes from the uncertainty of life events and changes in risk tolerance and preferences. These interact to make an individual’s risk calculation complex and dynamic.

Risk management for an individual is a moving target that is dynamic, multifaceted, and complex. We need a new approach to address it. One such approach is agent-based modeling. Agent-based models are used in fields in which complex dynamics are at work, from modeling traffic congestion on a highway to assessing the adequacy of exits for crowded venues, such as stadiums and arenas. Thus, it is not surprising that these are applicable to modeling material risk in financial markets.

This paper starts by highlighting market characteristics that are relevant for material risk. It then discusses how to extend current risk methods to deal with these risks by using agent-based modeling and by considering the interactions of market risk as well as the risk coming from the asset owner.


About the Authors

Richard Bookstaber
Richard Bookstaber

Richard Bookstaber is a noted expert in financial risk management and the co-founder of Fabric RQ, a platform that provides risk management to wealth managers and asset owners. He is the author of The End of Theory (Princeton University Press, 2017) and A Demon of Our Own Design (Wiley, 2007). His career has spanned chief risk officer roles on both the buy side at Moore Capital and Bridgewater and the sell side at Morgan Stanley and Salomon. Over the course of the 2008 financial crisis, Bookstaber served at the US SEC and the US Treasury, drafting the Volcker Rule, building out the risk management structure for the Financial Stability Oversight Council, and developing an agent-based model to assess financial vulnerabilities. Most recently he was the chief risk officer for the pension and endowment for the University of California. His roles have placed him at the center of the critical crises of the past three decades: the 1987 crash while at Morgan Stanley, the 1998 failure of Long-Term Capital Management (dubbed “Salomon North”) while overseeing risk at Salomon, and the aftermath of the 2008 financial crisis while working in the regulatory sphere. Bookstaber received a doctorate in economics from MIT.

Dhruv Sharma
Dhruv Sharma

Dhruv Sharma is head of portfolio intelligence at Fabric RQ, where he leads the development of risk models and risk management tools for wealth managers and asset owners. He was awarded a doctoral degree in statistical physics from the Ecole normale supérieure. Dr. Sharma’s doctoral work focused on building macroeconomic agent-based models to understand debt-driven business cycle dynamics and the application of spin-glass physics to study optimization in high dimensions.