Opinion: Chief Risk Officer Offers Easiest Way to Fight Stock Market Memes


In a world where everything from a pixelated flying cat to a girl staring at a fire can go viral and become a meme, can investors assess what could become a meme and impact their portfolios?

From my perspective as a risk manager, “memorization” will change the calculation of portfolio risk because the risk itself cannot be modeled, let alone measured. But it can be managed.

The genesis of risk itself comes from trading for entertainment and for participating in the online community, the result of investment applications that allow you to buy and sell fractions of shares with little or no cost. We’ve already seen glimmers of this in the explosive price action for GameStop GME,
and AMC AMC,
crowdsourced and detached from any financial or economic reality.

These so-called “Reddit gatherings” are just the start. Social media investment groups will literally turn the markets into a massively multiplayer online game. The thousands who worked together to defeat GameStop’s short sellers are not much different from the hundreds who banded together in the online game EverQuest to defeat the invincible dragon Kerafyrm.

The goals of these groups have nothing to do with a value assessment, or anything else, for that matter. It can be as frivolous as entertainment, or perhaps as noble as a social statement. Even investors might as well band together to move the price of an oil share over time so that the price chart traces a chimney. Or raise the price of the JBS Swift Food Processor to commemorate Taylor Swift’s birthday.

What could be entertainment for some will be an opportunity for profit for others. There is money to be made through misguided guidance and manipulation, further obscuring the risk footprint.

So what to do with a new type of risk emerging out of nowhere, arbitrary and unforeseen, unrelated to any financial or economic reality? The key is in the word “unrelated”. Like the aliens in The War of the Worlds Destroyed by Pathogens, “the humblest things God, in His wisdom, has put on this earth,” finance’s most basic risk containment strategy is best weapon against this new alien enemy. : diversification.

As we know, if a risk is independent, it can be diversified, literally reduced to unimportant if it constitutes a sufficiently small portion of the overall portfolio.

When I have a feeling of radical uncertainty, of the impression that I do not have a good understanding of the sources of risk, my instinct is to increase the diversification of the portfolio. This means removing myself from overweight positions and also reducing my dependence on correlations, as it is not known how these will evolve.

However, this is a strategy that comes at a cost. Assuming that all stocks are equally exposed to meme risk, the ideal diversification strategy for this risk is to hold equal weight in all holdings. Oversized positions will carry additional risk. The large exposure taken for the return opportunities must be balanced against a higher risk.

In either case, a move towards an equally weighted portfolio will be attractive from a risk perspective.

Rick Bookstaber is Founder and Chief Risk Officer at Fabric RQ. Previously, he held risk director positions at Morgan Stanley, Salomon Brothers, Bridgewater Associates and University of California Regents.

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