Blog: Measuring Risk Sentiment
Risk changes, not the appetite for risk.
Being a writer as well as an asset manager, I have always been intrigued by the evolution of words and phrases. Sometimes they start out as one thing and evolve into something else. For instance, the word "awful" in Olde English meant "filled with awe." But in the 1800s it grew to mean something terrible or bad, and still does.
I've been around long enough to see a number of investment terms change meaning. "Tracking error" is one. I ran index funds in the 1980s and "tracking error" was the measure of how much your fund deviated from the base index. It was a bad thing, an "error." Now tracking error is used as a measure of active risk. Active managers should have more "tracking error" or else they're just a closet index fund charging high fees. Why being more active is an "error" is unknown.
I bring this up as we enter 2025 because of the very positive sentiment that exists for the stocks and other risky assets. Inevitably many pundits describe this as "an increase in risk appetite." But is that really what's happening? Why would investors want to take on more risk if the magnitude of the risk is unchanged? Do they suddenly just feel more lucky today than yesterday? Or is the term "risk appetite," like "tracking error" being misused? If so, is that important?
If measuring risk sentiment as accurately as possible is important to you, the answer should be "yes." It is for me. Here's why.