Risk and Understanding All the Variables

One of the things that drives me the most insane is when data is presented as information without properly considering all of the variables. Over dinner with Martin a few weeks ago, I got off on a rant about an example of this. My target that night was the Dow Jones Industrial Average, which we hear about every time we turn on the financial news.

The Dow is a single point of data within the large sea of the economy. And, unfortunately, it presents a relatively skewed picture of the actual state of economic progress. I have been most enervated by it over the past couple years with the 2006-2007 psuedo-bull market that had every financial analyst talking about economic prosperity. (For example, see articles here, here, here, etc.).

Unfortunately, it’s pretty easy (about 2 hours of research and excel mojo) to show the illusory nature of the “bull market” that we have seen in the past 4 years. The US government has pursued an aggressive strategy of currency devaluation since 2002, and that plays heavily into the value of any asset valued in USD (e.g. the Dow). In order to understand the true nature of the state of the Dow, one must take into account all of the variables – in this case, the value of the currency that the price of the market is described in.

Dow raw and adjusted for the euro

Martin would point out that this is a somewhat naive analysis as I have only adjusted for one currency. To do a more robust analysis, we would have to average the currency impact across world regions, including the Chinese Yuan, Canadian Dollar and British Pound. However, even with a simple analysis, the results show a staggering change. While the DJIA enjoyed a raw increase of approximately 75% between 2003-2008, when adjusted for changes in currency value against the Euro, we see that increase drop to 35%.

This is significant – assuming that you got in at the absolute low (Feb 2003) and out at the top of each, this suggests that your actual annual rate of return on the investment went from 11.7% when just looking at the DJIA to 6.3% when adjusting for currency.

And I didn’t even factor in goods/services inflation or taxes. If I had, you would see that the currency loss here is the difference between making a profit and just barely breaking even on the investment.

Why am I talking about all this random financial stuff on a blog dedicated to risk and security (especially when I’m not an accountant)? Because this IS risk. This is the same kind of calculation that we make every day, and it is the same sort of mistake that I see risk management professionals make all the time. When calculating risk, we have a tendency to look only at the simple numbers – humans just aren’t good at multivariate analysis, especially in our head. So, we have a tendency to look for simple answers, often resorting the Tarzan method:

Dow up, good. Dow down, bad.

Unfortunately, it’s never quite that simple. If you don’t take into account all of the variables when considering the risk of your investments (whether financial, information security, or otherwise), you’re likely to significantly mis-read the potential for return on those investments.