Wednesday, September 01, 2010

Building Resilience

Jim Parker, Vice President, DFA Australia Limited
August 2010

'Risk' means different things to different people, but a common definition is as 'uncertainty'. Now, an entire science is being built around the idea of how we can cope better with the unknowable. And it has interesting parallels with investment.

What's known as 'Resilience Science' was the subject of a recent fascinating documentary on public radio in Australia, as an array of scientists revealed how new techniques are being developed to help society cope with rapid and unexpected economic, environmental and social change.1

"People are beginning to realise more and more that systems don't actually behave like we think they do," says Dr Brian Walker, a researcher with Australia's Commonwealth Scientific and Industrial Research Organisation.

The mistaken supposition, Dr Walker says, is that self-organising systems behave predictably and uniformly with small changes accumulating over time.

"But ... there are limits to the degree to which a system can cope with a shock and reorganise to keep functioning the same way," he says. "And once it goes past that limit, which we call a threshold or tipping point, it still keeps self-organising, but in a different direction, and often one that we don't like."

The role of resilience scientists, then, is to find and identify safe operating techniques within this system so that they can continue to cope when the unknowable and totally unexpected occurs.

Environmental journalist and author Mark Scheilstein provided an interesting analogy in citing the recent disastrous oil spill in the Gulf of Mexico or the flooding that followed Hurricane Katrina in 2005.

"When engineers look at major projects—whether levees in New Orleans or an oil rig in the Gulf of Mexico—not only do they have to plan for things they know about, but they have to plan for things they don't know about," he says.

"What happened in both of these instances is a very similar failing, in my mind on the part of the engineers" in that they failed to account for residual risk beyond the realms of their traditional expectations, Scheilstein says.

In environmental science, resilience is developed through building of reserve capacity, developing what's known as "modularity", diversifying food and energy sources, incorporating the idea of sustainability and increasing efficiency so that large exogenous shocks can be managed without the system falling apart.

Interestingly, similar ideas were explored in a financial market context in Sydney recently when Reserve Bank of Australia deputy governor Guy Debelle spoke to a conference on the concepts of risk and uncertainty.2

Debelle made the point that before the global financial crisis, many market participants had fallen victim to a form of hubris, believing that risk was totally quantifiable when in fact there would always be a degree of persistent uncertainty in the system that no model could account for.

"I don't want to get too 'Rumsfeldian' here, but an important element of risk management is to know what you don't know," the central banker said.

Because it was impossible to measure what we don’t know, policymakers and market participants needed to find ways of making the financial system as robust as possible in the face of this inherent and irreducible uncertainty.

So international policymakers in Basel are considering new requirements such as limiting the leverage of financial institutions, delivering a more robust funding structure to banks and enhancing their capital buffers.

Even then, the Reserve Bank deputy governor warned that no single model or combination of models can totally eliminate uncertainty.

"Risk measurement based on historical models can only take you so far. Judgement must play an important role," Debelle said. "Ultimately, the future is uncertain, in the sense that it cannot be quantified. The goal should be to design systems that are as robust as possible to this uncertainty."

The science of resilience is not unlike the approach to investment risk that Dimensional employs. That is, we must not only prepare for risky events that are within the confines of a neat model, but also must take account in our processes of what we don't know—outcomes beyond our conception.

This is achieved by building flexible, resilient, robust and dynamically integrated investment processes that can withstand rapid and unexpected change while maintaining the desired strategies.

Uncertainty in investment outcomes is dealt with through broad diversification, both across and within asset classes. The emphasis is on reducing the impact of idiosyncratic risk in a portfolio and focusing instead on risks that bear a long-term relationship to return.

Substitution is another technique. Traders are given discretion by being able to execute with a wide set of available orders. Not being wedded to an index or having strong convictions about particular securities also gives the investment team the sort of flexibility not available to other managers.

"Modularity" in science means the existence of modules within a network that can communicate and cooperate with each other, but which can operate independently if required. So it is with Dimensional's global investment process—with trading desks in Austin, Santa Monica, Sydney and London dynamically integrated but able to be self-sufficient if needed.

Finally, resilience science incorporates the idea that there are multiple ways of knowing and that our understanding of nature is always evolving. Creative solutions often emerge out of this process.

Dimensional takes a similar approach to investment, always testing its assumptions and encouraging a continuing dialogue between those who pursue theoretical research, those who do the practical implementation and the clients who keep us aware of their changing needs.

Ultimately, building resilience amid uncertainty is what our business is about.

1. Resilience Science, ‘Future Tense’, Australian Broadcasting Corporation, August 26, 2010
2. Guy Debelle, ‘On Risk and Uncertainty’, Risk Australia Conference, Reserve Bank of Australia, August 31, 2010