Portfolio risk management is similar to the Norden Bombsight.
What is the Norden Bombsight, and what do I mean exactly?
The Norden Bombsight was an engineering triumph; an analog computational device that allowed American bombers in World War II to drop their payloads accurately on their intended targets. In theory, it worked perfectly. The inventor bragged that he could drop a bomb in a pickle barrel and he was correct. In trials, the Norden Bombsight was amazingly accurate. In use during combat, however, the Norden Bombsight was not nearly as impressive.
Combat introduced things such as clouds, smoke, flak, and Messerschmidts. These were all absent during the “ideal” conditions under which a bomb could be dropped into a pickle barrel. For best results, the bombardier needed to actually see the intended target and the aircraft needed to fly slowly and steadily at as low an altitude as possible. Unfortunately, there often was cloud cover. Additionally, slow, steady, low altitude flight over enemy territory resulted in a greater probability of getting shot down. Naturally, pilots would fly at higher altitudes as fast as possible. Precisely when you needed the Norden Bombsight to perform its best it would fall short of expectations.
This is how risk management in portfolio management works as well. During “normal” market conditions, things like mean-variance optimization, value at risk, Sharpe ratios and diversification work beautifully. It’s when things are not “normal” that it all falls apart. Just like the Norden Bombsight, precisely the moment you need risk management to work its magic is when the wings come off. During a financial crisis, the correlations of almost all assets move towards “1” and portfolios that were once diversified start to move together lockstep, wiping out any diversification benefits.
So, what should we do? We can take our cue from the Army in World War II. They used the Norden Bombsight despite its shortcomings because it was the best tool they had. Present day risk management techniques are the best tools we currently have.
We should use them.
Today, with GPS and laser guided technology modern bombs really can be dropped into a pickle barrel during combat conditions. I am confident that eventually, our risk management techniques will evolve as well and someday portfolio risk management will be much more accurate.
Until then, here is an entertaining story about the Norden Bombsight from one of my favorite authors Malcolm Gladwell: