It is said that “the search for value” is what drives a huge amount of efforts over a long period of time in the financial markets and among finance scholars.
However, this is not wholly correct or half the story. The other half story and more imposing is “the search for [understanding] the risk”.
A bit historical background on this:
- Markowitz Modern Portfolio Theory is about giving equal weight to RISK as well as return (1952).
- Sharpe CAPM shows us that the expected return on risky assets is a function of its RISK (1964).
- 2M’s (Modigliani-Miller) 2 propositions (1958) said that the value of a company is a function of its business’s RISK and changing the capital structure or its financing side just will change how that risk is parceled up among the debt and share-holders.
- Fama’s Efficient Market Hypothesis explains the market that gave the mantle to CAPM, that is there is no free lunch as far as it relates to RISK (1970)
- Black-Scholes-Merton (1976)’s option pricing is coming from the needs to hedge the RISK.
So it all those 5 monumental points in finance history..all is about the RISK.
So, when we are building the financial models, the model should center on the risk. The models built are not about just looking at the resulting parameters, such as ROI, IRR, NPV, Equity Value, EPS, etc. but the risk measurement should be there and shown. A good financial model is providing us the insight into the risk.
Some models has managed to incorporate some modeling methods to deal with the uncertainty in the modelling, such as factoring the probability, sensitivity analysis, scenario analysis, simulation, break-event point analysis, stress-testing, VAR, Monte Carlo analysis, etc.
However, the risk should be understood not just as the NUMBER as there is no simple mechanical way to depict this. Logic and theory should be the foundation to grasp the RISK.
The complication with RISK is the inter [cross]-interaction among so many factors and elements of responses from the decisions being made in the financial markets, including factors that are coming from non-financial markets, such as politics, consumers behaviour and demand, technology, production and supply chain, innovation — in other words – EVERYTHING that HUMAN could make the decisions [betting and responding to] over it.