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Rick Bookstaber: Avoiding Complexity Is 'Risk 101'

The risk-management expert and author discusses the differences between risk tolerance and risk capacity, how market cycles impact risk, and how to keep things simple by being 'pre-armed.'

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Our guest this week is Rick Bookstaber. Rick is the head of risk of Fabric, a startup he founded to provide risk-management software to individual investors through the financial advisors who serve them. Prior to founding Fabric, Rick held a number of senior risk-management roles, most recently as chief risk officer at the University of California system, and before that at various hedge funds and banks, including Bridgewater, FrontPoint Partners, Morgan Stanley, and Salomon Brothers. He also served in the Obama administration, where his work included stints with the Financial Stability Oversight Council and at the SEC on the Volcker Rule and other regulations. Rick has authored several books, including A Demon of Our Own Design, which was published in 2007, as well as The End of Theory, which was published in 2017. Rick received his bachelor’s in economics at Brigham Young University and earned a doctorate in economics from MIT.

Background

Bio

Fabric

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, by Rick Bookstaber

The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction, by Rick Bookstaber

Risk Management Macro

7 Risks That Are Creating a New Market Paradigm,” by Rick Bookstaber, barrons.com, June 17, 2021.

Agent-Based Models for Financial Crises,” by Rick Bookstaber, bookstaber.com, Aug. 30, 2017.

Can Global Capitalism Survive in its Current Form?” by Rick Bookstaber, Age of Economics on youtube.com, March 6, 2021.

Bill Bernstein: We’re Starting to See All of the Signs of a Bubble,” The Long View Podcast, Morningstar.com, March 10, 2021.

A More Realistic Look at Risk,” by Amanda White, top1000funds.com, Oct. 6, 2017.

Can High Liquidity + Low Volatility = High Risk?” by Rick Bookstaber, rick.bookstaber.com, Aug. 23, 2007.

Our Low Risk (Low Volatility) World,” by Rick Bookstaber, rick.bookstaber.com, Nov. 4, 2017.

Building Forward-Looking Scenarios: Why You’re Doing It Wrong,” by Rick Bookstaber, Alicia Karspeck, and Govinda Quish, risk.net, Aug. 3, 2021.

Investments

How to Make Risk Management Work for Advisers,” by Rick Bookstaber, investmentnews.com, June 24, 2021.

Aladdin (BlackRock)

MSCI’s Principles of Sustainable Investing,” msci.com.

Organization and Culture

Adaptability Versus Optimization: The Cockroach Approach,” by Alex Barrow, macro-ops.com, Aug. 28, 2019.

Opinion: A Chief Risk Officer Offers the Simplest Way to Fight Back Against Stock-Market Memes,” by Rick Bookstaber, marketwatch.com, July 10, 2021.

This Is the Way Facebook Ends (and Maybe Apple and Google),” by Rick Bookstaber, rick.bookstaber.com, Jan. 28, 2018.

Facebook and the Awakening of our Private Selves,” by Rick Bookstaber, rick.bookstaber.com, April 1, 2018.

Transcript

Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar research services. And I’m Christine Benz, director of personal finance and retirement planning at Morningstar. Our guest this week is Rick Bookstaber. Rick is the head of risk of Fabric, a startup he founded to provide risk-management software to individual investors through the financial advisors who serve them. Prior to founding Fabric, Rick held a number of senior risk-management roles, most recently as chief risk officer at the University of California system, and before that at various hedge funds and banks, including Bridgewater, FrontPoint Partners, Morgan Stanley, and Salomon Brothers. He also served in the Obama administration, where his work included stints with the Financial Stability Oversight Council and at the SEC on the Volcker Rule and other regulations. Rick has authored several books, including A Demon of Our Own Design, which was published in 2007, as well as The End of Theory, which was published in 2017. Rick received his bachelor’s in economics at Brigham Young University and earned a doctorate in economics from MIT.

Jeff Ptak: Rick, welcome to The Long View.

Rick Bookstaber: Thanks for inviting me.

Ptak: It's our pleasure. To get started, I don't think everyone in our audience will be familiar with what a professional risk manager like yourself does. And so maybe a good starting point is you walking us through how it is you define risk. And whether that definition is universal, or whether it can vary depending on context or other factors. Could you do that?

Bookstaber: Sure. There are risk managers in a lot of different areas. When it comes to financial markets, the risk manager is really looking at market risk. So somebody has a portfolio, it could be the portfolios held by a hedge fund, it could be the various trading desk exposures at a bank, and the risk manager is basically trying to make sure everybody's aware of the potential for that portfolio to lose money if certain events might occur. So, it's simply a matter of looking at positions, measuring how they interrelate, so that you know if one event or another occurs, there's no surprise. There's always surprises that can happen in the market, but at least for something that you can look out and see as a potential event, you're not surprised to discover when that event occurs, that you've lost 15%. Because you know your risk is such that that wouldn't happen.

Christine Benz: In your writing, you've distinguished between risk tolerance and risk capacity. Could you explain the difference between the two, why it matters, and how that difference can be more clearly drawn and applied in practice?

Bookstaber: Risk tolerance is the amount of risk that you are willing to take. It's a psychological-based sense of risk. Risk capacity is the risk that you're capable of taking. My background is in the institutional space, so I'll give an institutional example: If you're a trader at a hedge fund, or if you're a pension-fund portfolio manager, your risk capacity is the amount of exposure that you're allowed to have--that's the amount of capital that you have at your disposal to invest. Your risk tolerance is how much you're willing to invest, given the nature of the market environments today. So, you can have very strong risk tolerance. But the fact is, you can only invest the amount that you have available to invest. So capacity is your constraint, in that case. You might have a lot of capital, but if you're very concerned about the market, then your tolerance is the constraint. And you're going to have capital available that you're just not putting at risk.

Ptak: I want to go back quickly to the first question, which was about definition of risk. And I think that you alluded to different ways in which risk management can be applied. But how do you define risk, maybe more specifically or quantitatively, we know that it's very common that people will look at things like standard deviation or value at risk or other sort of quantifiable measures of risk. I think in your writings you found some flaws with those approaches. So how have you tended to approach that in applying risk management in the context in which you have?

Bookstaber: First of all, risk isn't a number, whether it's value at risk, or however else you want to look at it. Risk really is a narrative because when something happens in the market it's not just one jolt and that's the end of it. So, when I look at risk, I look at it as a story. If I'm concerned about the risk, say from inflation, or from the potential of a bubble in technology, I'm not just saying, oh, the risk is 12. I don't know what 12 means in the concept of risk. What I'd be seeing is, here's the way that that type of event may play out. And depending on how it plays out, here's the path that risk might take. So, first order, you can use a number like value at risk, which is pretty standard, and say there's a 5% chance that you might lose more than say 25% on your portfolio. But that ignores the fact that the markets are dynamic, and that you can really present a type of a narrative for what might occur. So I, of course, use methods that come out as numbers, but behind the numbers to understand risk, you have to know the way you think risk might propagate--what are the things that might occur in the market and how, when those occur, they will unleash second- and third-order effects.

Benz: As human beings, we don't seem inclined to put risk front and center in the way we plan for future goals; we think more about the returns we can make or the yield we can earn. And then risk management is a bit of an afterthought. Why is this, and assuming you think it's not advisable, what can be done to inculcate a risk-management mindset in planning and decision-making?

Bookstaber: One thing that I'd say is now risk is becoming more and more of a central point of focus. One reason is people have more and more started to realize that it's pretty hard to generate any sort of an alpha in the markets; it's hard to beat the market on a return basis. So, if you're going to try to manage your portfolio, the place you can have the greatest impact is in the risk dimension, rather than the return dimension. I think that the way to get people to understand the importance of risk is simply that--for them to know the limits of what's possible in trying to reach for yield and trying to beat the market. And the more they pull back from feeling that that's something that's possible, they now have to say, “How can I then improve my position by getting rid of risks that are unnecessary or that can be either diversified or hedged away?”

Ptak: And so let's imagine that you get that point across to them. You say, “The focus shouldn't be on alpha, let's focus on mitigating the risks that we can mitigate.” And maybe it’s an individual investor, and they're trying to go through those progressions, I would imagine that one of the things that they would want to do is make sure that they're properly diversified consistent with their plan. What are other things that you think that they should focus on from your standpoint as a risk manager?

Bookstaber: I think the best way to do it--and you need to have the proper machinery to do this--is to look at risk not on an asset-by-asset basis, and also not look at risk overall in the portfolio on an aggregate basis, but use what are called risk factors. Risk factors are really the building block of risk. So, it might be things like exposure to sectors; exposure to different styles; are you a high-cap versus low-cap? Are you in value versus growth? Exposure to countries? And then you can say, “Do I have exposure in various risk areas?” For example, “Am I unusually exposed to China?” Well, it may be that all of your stocks are U.S. stocks, but yet they may have a lot of exposure to China, which you didn't realize because they have a strong supply chain relationship with China.

So that's the way really to get a handle on risk. It's not to look at risk asset by asset. It's not pulling everything together and looking at the aggregated risk of your portfolio, where you have to assume, how are things related? How are they correlated? It's looking at risk, risk factor by risk factor and deciding, do I really want to have that much exposure to technology? Do I really want to have that much exposure, as I just mentioned, to China? Does it turn out that I am very highly biased in growth versus value? That's really the cleanest way, I think, to try to decompose and analyze risk.

Benz: You're not a fan of risk-management approaches that lean heavily on historical market performance or scenario analysis. Explain why and how you'd approach risk management without relying on tools like past performance, as is pretty commonplace.

Bookstaber: Well, in fact, past performance is it. Almost every risk method that you see out there looks at what returns have done, how have they bounced up and down over the last one or two years. And if that's what risk has been like over last year or two, that's my best guess of what it'll look like in the future. And, it's interesting that we all know the mantra that past performance is not indicative of future returns. Past risk is not indicative of future risk. But people still use history. And I'm not arguing you don't use history. Of course, history has some value. But if you don't look at the market as it stands today, you're ignoring the essential information that you need to have to get a good assessment of risk. For example, if there's more leverage in the market now than there was over the last few years; if people are more concentrated in particular areas of the market now than they were in the past; if credit conditions are tightening--those things all are going to point to risk going forward, being higher than it has been in the past. So, I think you can use history, but you have to condition it on what's the market like right now versus what it's been like historically.

Ptak: We are going to shift to talk risks and macro. Risk management seems like, in some ways, an even lonelier endeavour now, given the way policymakers have pulled out all the stops, it seems like, to induce risk-taking, and also how risk-takers have been rewarded. For instance, crypto has taken off despite the huge risk it entails, and speculation seems quite rampant. As a risk manager do you see similarities between the current climate and other periods that preceded disruptive market pullbacks, like the tech bubble bursting or the financial crisis?

Bookstaber: There's two things I think that you're saying--one is that risk managers, not always, but more often than not, look bad, because you're always warning about things that might occur, and might occur means maybe they will occur with 5% or 10% probability. So, 90% of the time, you're concerned about things and they don't happen. So, it is kind of a lonely job in a sense because of that. But I think the other point that you're making is, the time that risk is the highest is the time that the markets have been doing incredibly well. So you sound more and more like this lone voice in the wilderness as things keep on going better and better in the market, as people get further and further out in front of their skis, as they lever more as they do new, innovative and risky types of strategies. And you don't know when the party's over. So, I've been concerned about the nature of risk and vulnerability in the market now for a while. I also was concerned before 2008. In fact, I had a book that came out in 2007, talking about how the markets were particularly vulnerable. And you can see the risk issues and the vulnerabilities for quite a while before anything is realized. And, in the meantime, everybody's saying, “Why are you telling me all this? Everything is fine; I'm making money.” So, you have to have a particular disposition to be able to be in the situation of being a risk manager.

Benz: You referenced credit earlier, and I wanted to follow up on that. High-yield bonds are yielding less than 4% right now, which is an all-time low. Spreads are also historically tight, the yields differential between high- and lower-quality bonds is narrow. Is the bond market complacent about credit risk right now?

Bookstaber: Yes, I think when you see spreads at the level they are now you have to wonder, it's part of the same level of optimism that is occurring in the markets broadly. But I'd say that when you see high-yield-bond spreads as narrow as they are today, there probably isn't the appreciation of the degree of credit risk that can occur. And so, one of the warning signs that I’d put out there to say that we are in a high-risk environment is that: that the credit spreads are not really signaling any notion of potential risk.

Ptak: Do you think that fiscal and monetary policymakers have become more skilled at navigating cycles and responding to shocks? And, if so, what are the implications for risk-taking and the payoff one should expect to reap investing in stocks and bonds?

Bookstaber: You would think that the central banks, the Fed will get better and better over time. They are always a little bit behind the game, though, because there are new strategies and innovations that come out that change the nature of the markets, from whatever they've been doing historically. What we saw from the Fed in March of last year, I think is an illustration of how the Fed has really, I don't want to say improved, but basically has improved in terms of its ability to deal with crisis. How it acted very, very quickly, very aggressively with the issues that were occurring in March as COVID was starting. There's one day where the Treasury market traded $250 million, this is the largest market in the world, and essentially it had shut down. And it was just breath taking, the speed and the aggressiveness with which the Fed took action to keep the markets from failure.

So, I think that's a great example of lessons learned from 2008, where things really occurred at a snail's pace, and because of that, we had a lot of problems that might have been avoidable. The problem, though, is you only have so many bullets. And the Fed can be the liquidity provider of last resort, so to speak, they can do a lot, but after a point, there's a limit to what they can provide to the markets. So, I think that we are in a position because of the willingness of the Fed to be aggressive. The willingness of the Fed to put out facilities for different markets, where historically they would not have been willing to go into those markets, means that we have more potential to avoid some sort of liquidity crisis than we have in the past. But the fact is, central banks still can only do so much.

Benz: We've interviewed author William Bernstein several times. In his writings, he's laid out his own risk framework where he distinguishes between recoverable short-term losses and volatility, which he calls shallow risk, and permanent loss of capital due to hyperinflation, prolonged deflation, devastation through war, geopolitics, and government confiscation, which he calls deep risk. Is a framework like this potentially useful? And if it is, how should individuals and advisors apply it?

Bookstaber: I think that's a great framework. I don't know it specifically. I was chief risk officer for five years at University of California's pension fund and endowment--we had like $160 billion. And whether you're an individual or you're a pension fund, you have a long time horizon--you don't have leverage, so you can't be forced out of the market. And so, there are some of these shallow risks that really might be bothersome to you, but you don't have to react to them. But there are what he's calling these deeper risks that are structural--I would call them structural risks. For example, I won't look at the current environment, but looking historically, at past times, whether it was the internet bubble or long-term capital management's failure, you get these very violent market events that are occurring, because people are highly leveraged, and if the market drops, they're forced to sell. And when they sell, it drops the market more, which means even more people are forced to sell.

So, you can find prices dropping 10%, 15%, 25%. But once everybody's forced out of their positions, everything recovers because there's nothing structural that has occurred. It's all the technicals of leverage and concentration of liquidity. Those things should not be a problem for somebody who has a long time horizon and cannot be forced out of the market. The things that are the problem are the things that you just mentioned: structural change in terms of inflation. A change in the nature of the market that will occur because of the realities of climate change, the shifts that will change in the market because of demographics. Things that really march along slowly, they're almost imperceptible month by month, but create real structural changes in the nature of the markets and the economy. Those are the things that if somebody is really aware of their portfolio and their timeframe, and has the patience, they can know which periods of volatility in the market really matter, and which are troublesome short term, but really they can just stand back and watch.

Ptak: So, to follow up on that, if I'm an individual or an advisor serving an individual and I'm trying to risk-manage to ward against these deep risks that we've been talking about--which it sounds like you also think of it as the real long-term threats to the success of a given plan or portfolio--what are things that I ought to consider doing that go beyond the standard conventions of diversifying assets widely? Are there other things that you think would be called for or that should be avoided, for that matter, in order to sort of mitigate those deeper risks?

Bookstaber: Well, you're usually starting from the standpoint of some benchmark, some index. So, if you have the freedom to invest without being compared to some benchmark, it's a different situation than if you have to adhere to a benchmark and any deviations from it might generate alpha for you, but also you might get called out. So absent that issue of are you benchmark-focused--so your returns are relative to benchmark--or is it absolute return that you care about. The most immediate thing is not so much what you do as what you don't do. And that's what I was alluding to earlier that you know what types of market events and what types of risks can be essentially ignored. It's painful short term, because you might see your portfolio drop 20% or 30%. But you realize it's a dynamic that will work its way through the market; the dust will settle, things will be back to normal, maybe in one year or maybe in three years. But it gets back to where it should be.

Something else, for example, climate change is an example of something where you know the nature of the world will be different as it works through the system. Fossil fuels are going to be reduced. There's going to be a move toward electric vehicles. There are certain geographic regions that are going to be highly stressed. And you don't have to wait for those events to actually occur. It's when people wake up and realize that those events will occur and reprice assets accordingly that essentially the market event is happening.

So, for example, right now Florida real estate is on everybody's minds, of course, because the tragedy with the condo that fell there. But you would know now, even though that's just the first shot across the bow, that you would not want to be aggressively buying real estate for your portfolio in Florida along the ocean. And you don't have to wait for the flooding to occur over time. And the investors won't wait--either it's happening now or in the year or two it'll happen, that prices will continue to drop to discount to the future reduction in value for those assets. So that'd be one example where you're recognizing a sea change in the nature of risk and you're making portfolio adjustments accordingly. But if you're doing things relative to the benchmark, you'll be deviating from that benchmark because the benchmark you're using still has a certain amount of assets in these areas, whether it's in fossil fuels or in oceanfront real estate.

Benz: It's pretty common to see risk defined as volatility or value at risk. Yet over longer periods, it's paid off to hold volatile assets like stocks. Given this it seems the real risk is failing to save enough to reap those rewards or not sticking with it long enough. So, is the correct risk-management approach to do everything possible to encourage savings and patience?

Bookstaber: Individuals are missing the superpower that they have in risk, compared to a lot of institutions. We always look at institutions, of course, having huge resources to develop risk management and so on. But the fact is that individuals have a long timeframe, unless you're right up against your retirement period, but for a typical person who's saving, they have this long timeframe to save. They can bypass a lot of the risk events that if you're an institution you have to worry about. And you can take advantage of the fact that very long term, the capital market assumptions for equities are something like, nominal returns around 7%, maybe 6.75%, maybe 7.5%. But long enough period, this is what most people would assume will occur.

So, the risk issue for an individual, in one sense, it's harder, but in another sense, which I would describe is easier than what's required for institutions. Because they don't have to worry about the month-by-month variability that occurs in a portfolio, and they can take advantage of the very long-term expect return to equities. Now, things change a little bit as your timeframe reduces and as you get closer to retirement, and you can't really absorb the short-term bumps up and down. But if somebody is in their 20s, or 30s, or 40s, then if they're saving at a constant rate, if they're holding a well-diversified portfolio, if they're not reacting up and down to every little bump in the market, that's a pretty good starting point.

Ptak: Building on that, and something else that I've seen you observe and write about, which is that an advisor’s job can be considerably harder than an institution's because an advisor not only needs to monitor and manage the portfolio's risk, but also the risk the client could pose to the plan’s success by misbehaving in essence--maybe they panic, and they have their advisor pull all their money out of the market at an inopportune time, and so on and so forth. So in view of that, do you think that one of the things that ought to be focused on is building a portfolio that the client can live with, basically not allowing perfect to be the enemy of good, where perfect is like a very precisely risk-optimized portfolio that has a lot of moving parts versus good, which is a portfolio that maybe isn't perfectly risk optimized, but has very few moving parts, and therefore the client is less likely to be thrown off by. Do you think there's merit to simplicity as part of a risk-management process?

Bookstaber: There's a lot to say there. First, to say something about the first part of what you're saying--that the irony of risk management for an individual, risk management that an advisor has to grapple with, is that it's more complex… Take the most complex hedge fund or bank in the world--the fact is, they have a lot of different positions, they have a lot of derivatives and things, but all they have to do is manage their returns. And they only have to manage it over periods of weeks or months. If you're an advisor, you have to manage over a long period and do it, where really you're clapping with two hands, because you have the market and what's going on there. And then you have the individual and how they may change their risk tolerance or in their preferences or what they want to do with their life experience.

The advisor’s job has dimensions to it that a bank, or a hedge fund, or a portfolio manager doesn't. And so, it has extra dimensions of complexity. But at the same time, as I mentioned earlier, if done the right way, the advisor--if the client is well informed--can avoid a lot of the bumps along the road that are really front and center for a hedge fund. But getting to the other point--to me the notion of optimization simply is wrong. You cannot optimize a portfolio because you're in a world that's constantly changing and changing in ways that you can't anticipate. So, you might get a portfolio that's exactly right, if the next while looks just like it did in the past, but of course the next while won't look just like it did in the past. If you know that the future is going to change, but change in ways that are not fully anticipatable, what do you do?

Well, you certainly don't fine-tune and optimize to the present. What you do is you create a portfolio, like you're saying, that's simple. That's what I would call coarse, in that it will do well enough, in many different possible worlds, even though it may not be precisely the best in any one of those worlds. The book that I mentioned earlier that I wrote right before the 2008 crisis is called A Demon of Our Own Design. And there I talked about the need to reduce complexity in the markets, that we should be getting rid of these collateralized debt obligations, and complex swaps and so on. And to hit home that point, I talked about what are the animals that have survived the longest as the world has changed over eons of time? And, one insect that's done very well--we wish it probably hadn't--but it's really done very well, is the cockroach.

Cockroaches have been around as jungles have turned to deserts and deserts have turned into cities. But the cockroaches are not optimal, fine-tuned insects. They don't see, they don't hear. All they do is move in the opposite direction of a gust of wind against these little hairs on their legs. So, they'll never win Insect of the Year award. But they do well enough in many environments. What you want to do is be like the cockroach in your investing and have a portfolio that can do well in the face of many different environments that may not be fully anticipated.

Benz: One of the things that listeners to this podcast do is outsource their investment management to others, like a fund manager. If you're them, and you're trying to assess how good a fund manager is at assessing and managing risk, what kinds of things are you looking at?

Bookstaber: I would first see how patient they are in terms of how they set up their portfolio, whether they have a timeframe, and how they make decisions that are similar to the timeframe that you have. Whether they themselves are reactive to short-term bumps in the market or not. In other words, are they in sync with you? Are they dancing to the same music that you are in terms of the needs that you have? And then in terms of risk management, it's really seeing if they are moving, well there's obviously things like style drift, and so on. So, you want to make sure that they're constant in terms of the style that they have in their prospectus. But what is their exposure to various risk factors? And is that exposure something that's related to the objectives that they have. So, if somebody say, has a lot of exposure to mid-caps, when they're supposed to be a high-cap manager, obviously, you have a risk exposure that's not suitable given their objective.

If you start off by saying, what's your objective? How quickly are you going to make adjustments in the portfolio? How will you react to the short-term or shallow types of risks? And what is your exposure to various risk factors in the market? Then you have a good basis for understanding the foundation of how they're making their investment decisions. The reason I think risk management should be front and center rather than an afterthought is, it should be the foundation layer on which decisions are then made. So, you start by saying, how much value at risk am I willing to take? Value at risk is great. Am I willing to see returns go up and down, month by month by 1% and 2% and 3%, or should it really be typically 0.5%, 1%? What am I willing to take exposure in? If I'm a U.S. fund, I better not have risk-factor exposure to emerging markets.

So, these are the sorts of questions that you can ask. And then so long as that foundation is well defined and they're resting on that foundation, then the decisions that they make from portfolio, opportunistic standpoint are well set. You don't have to second guess every opportunistic decision, every decision that they're doing to try to generate alpha, if that's what their objective is.

Ptak: Building on the point you make about opportunism. In the investment business as you know, one concept that's gained popularity in recent years is the idea of active share, the notion that to beat the index, you need to depart meaningfully from it. I think that probably it's not just about departing from it, you also need to be right. But putting that aside, it's obviously true that you have to be different. So, from a risk-manager standpoint, is that the sort of thing that is tolerable given the fact that that also represents what might be called tracking error, which a risk manager might define as risk? And, if that's the case, it seems like the two are potentially in conflict with one another. So how do you draw that line of affording a skilled investor enough room to operate so that they can exploit opportunities without taking on too much risk, if you're defining it from a tracking-error standpoint?

Bookstaber: The key of value-added risk management is to allow a portfolio manager to exactly do that. You're not doing a very good job as risk manager, if all you're doing is constantly saying watch out, be careful. Risk management is taking risk but doing it in a managed way. And so, if somebody is trying to be opportunistic--of course, they have to be overweight or underweight relative to whatever the benchmark is. But you want to define ahead of time, what is the extent of over- or underweighting? And in what dimensions, with what risk factors do you want to be over- or underweighted. And now, you're free to paint on that canvas. So, the whole idea of risk management is to facilitate the ability for somebody to take the risks, to try to seize opportunities within a defined capacity, where the capacity to do it is based on the individual's risk tolerance.

In the various positions I've had, I was the head of risk at Salomon Brothers, which at the time--this was in the 1990s--was the biggest risk-taking organization in the world. They had a big proprietary trading desk, and so on. And we had, during a major financial blowup from long-term capital management, we had $100 million loss, which at the time--this was 1998--was a big loss on our Treasury desk. And there was a loss because of a disequilibrium between, this is somewhat technical, but basically a 19.5-year and a 20-year bond. And the difference between the 19.5-year and a 20-year bond is almost nothing. But because the markets were behaving so poorly, you had this big gap. And I was in charge of risk management. And I basically proposed that we add to the position that we had on, which was already down $100 million. Why? Because I understood the level of the parameters within which we had agreed to operate in terms of risk. And we could take that position and still be within those parameters. So, we were still adequately managing risk. But we could take this great opportunity as we were doing so.

So, the notion of risk management should go hand in hand with opportunity. In fact, one of our annual reports, about three years ago at the University of California, had two front pages. If you opened it on one side, it was Opportunity. If you turn the annual report around and opened up the other side, it was Risk. And, so our whole point was that risk and opportunity go hand in hand; one helps contribute to the other, it's not trying to stymie the other.

Benz: Risk management is going mainstream as some risk-management tools that were once the province of larger institutions are made available to financial advisors through different platforms. Probably the most prominent example is BlackRock's Aladdin Wealth solution. If you're an advisor, kicking the tires on a system like this, what are the key questions to ask?

Bookstaber: I think when you're looking at risk-management systems, I'd say the key thing, and we sort of touched on this before--one thing I would want to know is, is it rooted just in history? So am I always going to be looking at risk through simply the rear view mirror, or does it add some context for the market as it stands today? The second thing that I think is very important, and I believe the BlackRock system does this, is does it use a factor approach? Because factors are really the basic building blocks for risk. So, you want to be able to decompose your portfolio into its exposure to different types of risk factors. And then, when you look at risk going forward, you not only want to know what has risk been like historically--of course, you do want to know that. You want to know what is the nature of the markets today? And you want to know, what are the sorts of things that might go wrong going forward? What are the scenarios of concern?

So, you want to have history but not depend on just history; you want to have risk factors; you want to be able to take the current market as context; and you want to look at different possible scenarios in an intelligent way. And, by intelligent, I mean to understand that a scenario is really a story. It's really a narrative. If somebody says, “Well, one scenario is a pullback in the FANG stocks, the large-tech stocks, and my scenario is they dropped 15%.” That's not very helpful. Anybody can sit there and just say, “If this happens, my guess is things will drop 20%.” What you need to be able to say is, “Here's the reason they will drop, here's the force that will lead them to drop. And here's how they will recover.” You want to trace out the story, the narrative, and the path of how a scenario will evolve.

We use the BlackRock Aladdin system, as well as the MSCI system at University of California. So, I'm familiar with the institutional version of both of those, I'm not so familiar with the kind of Aladdin (light) or whatever it's called for individuals. But I think those are the key things that you want to do. Another way to think of it is, you want to have something more than just looking at history, you want to have something more than just boiling down risk into a number. And you want to be able to look at the central building blocks of risk looking at factors.

Ptak: I'm going to shift to organization and culture. You've headed up risk at some very large organizations that you've referenced. It's not common to have a risk-management role or department at smaller firms. Do you think that's a function of organizational complexity? And, if so, is it complexity that should be managed rather than risk? Or do you think risk management get short shrift at a lot of places that ought to make it a priority?

Bookstaber: Risk 101 is: avoid complexity. This is the lesson of the cockroach. If you're in an organization where you are holding a simple set of stocks or ETFs that are plain-vanilla ETFs without any strange things going on, it's easier to understand where your risks are. If you start dealing with ETFs on illiquid instruments, ETFs that have nonlinearities to them, then you're adding complexity that starts to demand more and more of risk management. But I think you still need to understand even if you have a fairly simple portfolio, you need to be pre-armed. So that given the types of events that can occur either on the market side or on the client side, you know ahead of time what those might imply for the portfolio and for the ability for the client to get to their goals. And, it's a little bit like doing training exercises if you're in the military. To know before the event actually occurs, that if this event occurs, here is what it might do to your portfolio, here's what that might do for your potential in getting to your goals.

Knowing that before the event will help people better gear-up and prepare themselves, so they don't do something foolish when it occurs. And that's the type of risk management that everybody should have, even if you do avoid complexity. And that gets, again to the point of being able to be forward-looking in terms of risk and being able to take any scenario or any type of sequence of market events and turning it into a story or into a narrative, so that it's something that an advisor and the client can intuitively understand, based on their own life experience.

Benz: What does it look like when risk management is working as it should? Uncertainty, volatility, and short-term setbacks go with the territory. So, it doesn't seem like the absence of those things is necessarily evidence that you've successfully managed risk; it could just mean that you've taken those risks off the table, but in their place introduced other risks like not meeting future goals. So, what should one see and not see when risk management is doing its job?

Bookstaber: I think the best way to think of it is you have a set of preferences or risk tolerance; you have a set of goals that you want to look to going forward. And then you have surprises that get in the way--it's a little bit like you're walking down a path and every now and then there's a thunderstorm. You want to be pre-armed for the many different paths that you might end up walking down. Because what's really going on, when we look going forward, we have a goal at the end. But we're going to be served up any one of a number of different possible worlds, different paths that get us to our end point. And we want to be able to survey as many of those possible paths or worlds as we can, so that as we're walking along, we understand where we are at that point in time, and we can accommodate and make the reasonable adjustments. We're not surprised. And we don't take action based on the surprise that is inconsistent with what would make sense based on our longer-term goal.

This includes things I've already mentioned, and I think that are pretty intuitive for us but sometimes we lose sight of it in the moment. Understanding that we have a longer time frame than the variabilities that occur in the market. Understanding that risk can come from many dimensions. There are many different risk factors and that we are OK with having exposure to some of those factors, and maybe we don't want to have exposure to others. So, you basically are going to have a situation where you've made a realistic goal. You have a portfolio that gives you a good sense of a glide path to that goal. And you have pre-planned in your mind how you might react, or how the portfolio might best react, if you end up running along the path that's different than what you thought you would have run through.

Ptak: Shifting gears a bit. If a firm like Robinhood engaged you and said “Look, we know we have a lot of accountholders who are taking on way more risks than they should. What should we do to get through to them?” What would you advise Robinhood to do in that situation?

Bookstaber: Essentially people can do dinner and the movie-size trades for apparently no cost. So there's a number of things going on, but one of the things that's going on with Robinhood, is it's turned investing into entertainment and sort of a multiplayer game. It's put into social media context. So, there's a community involved. Now, is that really investments? That's something new to the markets, so naturally, as we've seen with GameStop, can create risks for the markets that weren't there before. I think if you serve out to people, a platform, which they decide to use as a social media platform, and as sort of entertainment, I don't know that you can talk about risk in that. And, if they're doing things in small enough size--it's a little bit like somebody buying a lottery ticket or something--if you do something that doesn't make sense from a risk-management standpoint, but you're doing it in such a small size, that basically it's diversified, fine.

The problem is, if that game of mentality expands out to where it no longer is a lottery ticket-size event, and it's a meaningful amount of an individual's wealth. And there the whole notion of having something on your phone where you can trade in and out quickly, you can have little endorphin hits, the way that you do when you do Instagram posts, is really antithetical to the notion of investing, especially for an individual. I don't know what the solution is to it. But there is a problem there for individuals, because what social media does, and social media is basically structured to allow people to get these endorphin hits by doing posts or seeing posts and getting likes and so on. And they're constantly on their phone, and there's a whole science and strategy to that.

If social media of that type goes into the investment world, then what people will be doing is against their best interests for long-term investing. Can we control and regulate what goes on with social media? We can't do that. So, I don't know how we can expect to do the same, if it moves into the investment sphere through apps like Robinhood. This may be for the millennials, something that they learn from and just say OK, I'm going to differentiate my social media presence from my investment strategies, or it’s maybe something that ends up becoming a problem for that generation.

Ptak: Rick, we've never done an episode on risk management and are glad to have had you as our guide on that journey. Thanks for your time and insights today. We enjoyed the conversation.

Bookstaber: Thanks for having me on.

Benz: Thanks so much.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

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Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)