Author: John Adams
“Prudence is a rich, ugly old maid courted by incapacity.” – William Blake
Our culture pulls no punches when talking about people who avoid risk. Risk-takers are adorned with adjectives such as swash-buckling and fearless, while those who seek to avoid risk are described in a tone that William Blake adopts above. This is not a bad thing. Foundations of our civilization have been built by explorers, inventors, discoverers and tinkerers. Without them, we will still be eating uncooked meat under a poor shelter of rocks in the plains of Africa, where Home Erectus first took steps.
But, for a professional investor, I’m certain that most of us can agree, our culture is a terrible guide of how to think about risk. People who give us their money to invest, do not usually expect us to take asymmetric risk in search of wild returns. Most expect us to provide market-beating return with a mind-numbing regularity. Why is that? This is because people are giving us their savings–savings that they hope will anchor their own risk-taking, whether it be a career move, or opening a new business. Social utility of professional investing is to conserve and grow these savings that act as a safety-reserve for risk-takers of our society. If the professional investors themselves sought risk in hope of spectacular gains, we fail at our primary task, expose clients to more risk than they had planned to undertake, and thus eventually numb the animal spirits of the society. But, risk is a conjoined twin of return. We can’t avoid risk. This means that we have to accept and manage risk. If we simply needed to avoid risk, we could simply steer away from opportunities that entailed risk. But, instead we have a more difficult task in front of us. We do not face a binary choice–seek or avoid risk, but rather a task where we compare risk and returns that entail finely calibrated assumptions. We must be good appraisers of risk.
Given that, how should one think about risk? What is risk? How is risk different from uncertainty? How do we measure risk? This book tries to answer some of these questions. Of course, there are no easy answers. I would recommend reading the book, as it is a great thought-provoking exercise.
Who should think about risk?
John Adams says that risk analysis cannot be outsourced. He talks about road accidents in the United Kingdom as an example (as an aside, if you read this book, be ready to learn a lot about road accident statistics, as that is almost a third of the book). Adams says that assessing risk requires a balancing act, and when risk-taking and risk-assessment is done in separate places, it is hard to identify where the balancing act is done. He suggests the division of labor in risk-management as the reason for lack of improvement in accident statistics despite the multitude of road improvement and vehicle safety regulations. This is a strike against risk-management divisions that are often required in large investment houses, and extending Adams’ logic, this construct would be futile.
Risks and its manifestations are non-linear
The world is a complex non-linear system. A relatively small rupture in tectonic plates releases enough energy to cause widespread havoc, which is multiplied by complex systems overlaid by humans such as nuclear reactors and supply chains spanning four continents. Planned murder of ~3,000 individuals can swiftly lead to death of 300 times as many humans and near-bankruptcy of a nation that was in an enviable fiscal position only 10 years earlier.
Investments, that are often levered by financial construction, multiply the non-linearity. Adams says that small changes in a complex non-linear system can cause significant and unpredictable effects. Hence, it behooves us to pay considerable attention to risk.
How is risk different from uncertainty?
According to Frank Knight, Adams says, if you don’t know what will happen, but you know the odds, that’s risk, and if you don’t even know the odds, that’s uncertainty. Uncertainty is unescapable. People are usually willing to take risk, but few willingly sign up for uncertainty. Even Russian Roulette players, purveyors of extreme risk, know their odds.
Investing can be thought of as (1) converting uncertainty to risk, and (2) refining risk by picking more well-informed odds than what the market is suggesting.
But, how can we select odds for events in future? Adams says that future is unseen, uncertain and subjective, except in minds of people attempting to anticipate it. Thus, I think that there’re two ways to select odds. First, one can shape the future. A skeptic would say that Al Gore’s hedge fund is trying to do the same by betting on same events that he is advocating as a public speaker, journalist and film-maker. Or, as an alternative, we can correctly identify people with the most power to shape the future, understand what drives them, and then bet on their actions. This, of course, is no simple task. I believe that only feasible way of coming close to identifying the true power-brokers is to study history.
Risk not only impacts valuation, but our holding behavior
Losses directly affect our abilities to make decisions, as they confront us emotionally in a far bigger way than returns do. By affecting our psyche, losses may make us take poor decisions–whether it be a decision to buy more, or sell in a panic. Being cognizant of our personal inflection point, where loss of confidence and decision ability sets in, is important, and hence it is important to target the appropriate level of risk. Adams quotes Ulrich Beck and suggests that for one to manage risk, one has to make it perceptible. Beck, for example, suggests that nuclear policy would be vastly difference if we could smell radiation. As investors, we need that ability to ‘smell’ risk. For this, we need to invest more, whether in real or imagined money, so we can feel smell and taste the risk.
Identify the feedback system
Adams says that many systems embody positive feedback, which make them self-amplifying processes. Negative feedbacks are seen in long-surviving stable systems, like earth’s atmosphere. of course, the former is significantly riskier than the latter.
There’s no ‘objective risk’
This is a simply another way of saying that there’s no one single indisputable measure of risk, volatility included. Adams says that human behavior will always be unpredictable, because it is in response to other human behavior, including ours. Thus, there’s no way to capture ‘objective risk’ despite the amount of processing power at our disposal. Even if a model could estimate risk, that would be used to merely guide behavior that it was supposed to predict. For 8th grade science fans, this is reminiscent of the Heisenberg’s Uncertainty Principle.
1. Do not outsource risk analysis.
2. Avoid simplistic linear assumptions, as the world is nonlinear.
3. Differentiate risk from uncertainty. Quantify and fine-tune to better assess odds.
4. Both risk and uncertainty can have both positive and negative outcomes. Downward risks and uncertainties should be accounted for, and the happy outcomes can be considered as a bonus.
5. Invest in made-up portfolios to learn how to ‘smell’ risk.
Follow-up book: Risk, Uncertainty and Profit by Frank Knight.