Order and chaos – given the choice, humans would usually choose order.  Sure, we love to explore, but as we do so we also love to categorize, to organize, to create boxes and silos of knowledge.  M.C. Escher summarized these tendencies by noting, “We adore chaos because we love to produce order.”

The Limits of Risk Analysis

Nowhere is this more true than in finance.  Over the last 20 years our tools and models have reached ever-higher levels of sophistication and complication, and our understanding of risk has become deeper and more detailed.  When I began my career as a portfolio manager in the early 1990s, conversations with investors were usually creative “what if” discussions of companies and products, and the notion of risk for a fundamental investor was often limited to an examination of top holdings or industry exposures.

By the mid-2000s, many of those discussions had evolved into complicated debates over tracking error and active bets, incomprehensible to anyone outside of our own professional circles.  Our tools had improved, and these statistics were helpful, but along the way we may have lost some common sense and connection to the real world in which our investments live.

The advantage to increased order over chaos in investing is clear:  we now have better measures of correlated risks, counterparty risks, and all sorts of nuanced relationships that are not obvious from a simple glance at top holdings.  However, with all of our detailed reporting and tools, it’s easy to forget one central and uncomfortable truth:  these measures are incomplete.

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Katherine Collins is Founder and CEO of Honeybee Capital and author of The Nature of Investing. Previously, Katherine served at Fidelity Management and Research as head of US Equity Research and Portfolio Manager.