(New) Limitations of risk management by selling

May 12, 2025
by Noriyuki Morimoto

In investment, the most simple and basic way to manage risk is to immediately sell assets when you sense danger. This is risk management by selling.

This method of risk management assumes that all investment assets are sellable. When they are not, risk management does not function. In this sense, the salability, or liquidity, of assets is critically important, and the limits of salability define the limits of risk management.

Then, what is liquidity? Actually, if price and time are not an issue, there is no asset in the world that cannot be sold. Anything can be sold, if extremely cheap or over a long period of time. However, salability in this sense is useless for risk management.

Liquidity, therefore, is the ability to sell immediately at a reasonable price. Herein lies the limit of liquidity in risk management.

The attributes of an investment, whether in bonds or stocks, are not stable. In other words, their value can fluctuate. The problem is when a loss of value is expected. However, in order to discuss the possibility of a loss of value, it is assumed that the value can be rationally and objectively determined, evaluated, and measured.

As long as its value can be assessed, an asset can be valued and priced while incorporating the assumption of damage. Therefore, it can be sold immediately at a reasonable price. However, in a situation where value cannot be determined, there is no way to put a price on the asset, so it cannot be sold at a reasonable price. In other words, liquidity is lost.

So, what is a situation in which value judgments cannot be made? The answer is a major market disruption, or crisis, as it is called.

Here, we see that there is a fundamental contradiction. To begin with, a crisis is the very situation where risk management by selling needs to be executed, as the possibility of loss of value is higher. But when it happens, in many cases, the assets are no longer liquid.

In a crisis, a kind of panic triggers forced selling, which will result in a sale at an extremely low price. Moreover, this transaction price carries the weight of being a fact. A market crash and deepening crisis unfolds. In other words, risk management by selling does not work in a crisis; on the contrary, it accelerates the crisis.

 

[Category /Strategic Investment]