Getting risk’s number?

Did U.S. citizens feel any more secure after Washington downgraded the terrorist threat nationally from orange to yellow on September 24? Probably not.

Did U.S. citizens feel any more secure after Washington downgraded the terrorist threat nationally from orange to yellow on September 24? Probably not.

A heightened awareness of danger of all sorts in these financially as well as geopolitically turbulent times has only made our inability to measure most risks with any certainty all the more apparent.

That shortcoming is evident in the hedge fund business, following several years of rapid growth. One reason for the funds’ popularity is that their returns appear to carry less risk than do other investment vehicles.

But as Senior Editor Hal Lux details in our cover story this month (“Risk Gets Riskier”), the primary method for calibrating the trade-off between risk and reward -- the Sharpe ratio -- isn’t really up to the task. “Hedge fund promoters love talking about Sharpe ratios, but they appear to be mostly meaningless for hedge funds,” says Lux.

Even the inventor of the Sharpe ratio -- Nobel prizewinner William Sharpe -- believes it is being asked to do more than it was intended to when he devised it as a young University of Washington professor 40 years ago. As he tells Lux with refreshing candor, “The Sharpe ratio is oversold.” In his view calculating the ratio should be only the starting point in a much more comprehensive review of an investor’s strategy -- not the ultimate arbiter of the risk profile.

“Sharpe ratios still work fine for many mainstream investments, but pension funds that have bought into hedge funds just based on their Sharpes might want to take another look,” says Lux, a University of Chicago MBA and the rare financial journalist who actually understands the theory behind the Sharpe ratio.

Assessing investment risk isn’t easy -- just consider Argentina. Every time the country seems on the verge of realizing its vast potential, it manages to fall back into economic, political and social chaos. This has been going on for almost three quarters of a century. As contributor Judith Evans points out in “Into the Void” (see story), these repeated failures are forcing the country to reexamine more than just its near-term economic policies: They’re leading to a discussion about Argentina’s collective pysche. That’s going to be difficult to capture in a simple, color-coded risk assessment. And you can’t put a number on it.

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