The scientist who developed the Saturn 5 rocket that launched the first Apollo mission to the moon put it this way: “You want a valve that doesn’t leak and you try everything possible to develop one. But the real world provides you with a leaky valve. You have to determine how much leaking you can tolerate.” (Obituary of Arthur Rudoloph, in the New York Times, January 3, 1996)
— Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk
Risk is tricky.
Imagine you were sitting in a board room six months ago, planning the 2020 March Madness basketball tournament. You were to give a presentation on risk (no one read your email). Everyone prepared by getting an extra blonde espresso shot after lunch, naturally expecting you to give the same terrorism speech you have been giving for 18 years.
Instead, you said, “Have we considered the following: Someone in Wuhan, yes Wu-Han — it’s in China, Mark — is going to eat a bat. That bat will be carrying something called the COVID-19 virus. Trust me, it’s bad. Suppose the bat is prepared medium-rare or sashimi, and the person contracts the virus from it…I’m not done. The virus is deadlier than the seasonal flu and could spread to the United States. We cancel the tournament to prevent more deaths than we would see in a terrorist attack.”
Best case scenario: You do not get invited to happy hour.
Worst case scenario: You are right.
How should we think about this?
Philosophy of Risk
97% of all Wikipedia articles eventually lead to the article Philosophy. (If you want to try it out: Repeatedly click the first link of the main text on any article.)
The implication is that everything is ultimately dependent on philosophy. Your actions and views regarding risk (and everything else) reflect your philosophy of it. For instance, some people have the philosophy of: everything happens for a reason. I am curious how people square that view with COVID-19, but I will grab that third rail another day.
When people ask for my view on something that involves risk and uncertainty, specifically finance, I respond like Michelangelo when asked about his famous sculpture: “I just chipped away the stone that didn’t look like David.”
If you chip away everything that looks like risk and downside, you are left with good things and upside. This is more of a thought experiment than end-goal because every activity involves risk and uncertainty. As I used to remind my chief credit officer, we are in the risk mitigation business, not the risk avoidance business.
The irony about risk is: The more you are focused on risk, the less risk there is. You get into trouble when you stop thinking about risk.
This requires being skeptical, especially of your own ideas. Most people do not like doubting their own ideas, especially enough to overturn them. At the same time, people do not like losing money. Unfortunately, these are mutually exclusive.
This is the world providing you with a leaky valve.
Whether you are trying to launch a rocket, make money, or DM that person you like, it is hard to balance enthusiasm and caution, especially for Humans. However, we should all be interested in achieving better-than-random outcomes. You have to balance enthusiasm and caution to achieve better-than-random outcomes.
I stress better-than-random because:
1) A majority of things that happen are random (e.g. You are here because your parents met. How did they meet? Chance.).
2) Good things happen from terrible decisions and vice versa — collectively known as luck.
We want to know what we are dealing with, so we need the ability to distinguish between them. This is why we should study risk, luck, and philosophy.
Types of Risk
I have been reading Howard Marks’ Memos from the Chairman for about 10 years. In rereading several in writing this post, I realized that his views shaped mine, so if you read them, you will notice the overlap.
To summarize, Marks points out 24 types of risk.
- Losing money – The possibility of permanent loss.
- Falling short – Not having enough money to live on.
- Missing opportunities – Not taking enough risk.
- FOMO (Fear of Missing Out) – Following others into risky investments because of envy.
- Credit – The risk that a borrower will be unable to make principal & interest payments when due.
- Illiquidity – The inability to sell at intrinsic value when you need the money.
- Concentration – Not being diversified.
- Leverage – Borrowed money magnifies gains and losses.
- Funding – Having money available immediately. Similar to illiquidity.
- Investment Manager – What if you pick the wrong one?
- Over-diversification – The impact from any one investment is diluted. Quality standards may go down.
- Volatility – Temporary price fluctuations (see Loss vs. Volatility below).
- Basis – Arbitrageurs take advantage of similar things being priced differently. They logically expect the prices to converge. Sometimes, they don’t and go the opposite way they should. This is basis risk.
- Model – A model is only as good as its assumptions. Overconfidence in a faulty model can lead to unexpected losses.
- Black Swan – The highly improbable or unimaginable event that happens (e.g. Coronavirus and canceling March Madness).
- Career – Doing unpopular things and being wrong, even temporarily, can cause you to get fired by either your boss or clients. This may cause some people to choose avoiding embarrassment over long-term returns.
- Headline – When you mess up so badly you make it in the news.
- Event – Owners in a company taking on excessive debt to maximize good outcomes, leaving the debt holders in a riskier position than contemplated.
- Fundamental – Assets or companies under-perform in the real world.
- Valuation – Overpaying for an investment.
- Correlation – Seemingly unrelated things moving in price together. In panics, they say all correlations go to one, meaning everyone is trying to exit their investments and convert to cash at the same time.
- Interest Rate – All things being equal, higher interest rates lower the value of all financial assets, specifically fixed income.
- Purchasing Power – The risk that cash in the future will buy you less than it does today (i.e. inflation).
- Upside – Underexposed to good things (e.g. being in cash and the stock market going up 400%).
Know What You Are Doing
Given that there are a few hundred years’ worth of reading on the topic, I will keep it as brief and practical as possible. This necessitates intentional and accidental acts of omission. I will expand on certain topics in future posts.
Many of the best thoughts on risk are simple, like Buffett’s: Risk comes from not knowing what you are doing. Nassim Taleb has written three books on one idea. To know what you are doing and incorporating Taleb’s one idea into your actions takes work.
This is an archetypal conversation I have:
Person 1: How should I invest my money?
Me: Read these five books and let’s chat after that.
Person 1: (Thinking to himself: Yeah, I’m not going to do that.) Oh okay, thanks!
I accidentally stumbled onto this, but it is actually a test: Are you willing to put in the work to give yourself a better-than-random outcome? If that involves doing something you don’t want to do, the answer is often an emphatic, silent NO. This is an example of people torturing reality to make it fit how they already view the world (philosophy). Yes, I want the answer, but that isn’t the answer I was looking for.
Here is the thing: You want a simple answer and you want it now. The simple answer does not exist, and if it does, it requires work to arrive at the simple answer and even more to develop the conviction to stick with it.
Suppose I said to Person 1, “Buy VOO (Vanguard’s S&P 500 index fund) and sell it in 40 years.” But, if I say that, inevitably I will get a text a few years later: “Hey, should I sell my stocks? What does this coronavirus mean for the stock market?”
It means it will do what it has always done: It will fluctuate. Anyone who tells you otherwise, is bullshitting you. It is valid to be skeptical of a strategy. The issue is more about the emotional response from price declines.
If you get nervous or scared when the stock market is down, that is perfectly rational if you did not develop your strategy. If someone else developed it, then it is unlikely that you have developed the conviction to stick with it. If things start going differently than you hoped, you start doubting the strategy.
This is great, but the time to start doing all of this is before you implemented the strategy.
You are responsible for managing your risk. Assigning responsibility to someone else is a risk.
Loss vs. Volatility
I use the following definitions of risk:
- the possibility that something unpleasant or unwelcome will happen
- permanently losing money
As Marks says, in finance, you will often hear people talk about volatility as a definition of risk. In this sense, volatility means rapid price changes, usually for the worse. You will notice no one ever complains about volatility to the upside.
This comes from the human desire and preference for predictable, consistent, and most importantly, favorable, recurring outcomes.
To be fair to the academics, all things being equal, a less volatile portfolio is better than a more volatile one. So, volatility is a risk. However, what we ultimately care about is permanent price movements, not temporary price movements. You probably have an asset in your portfolio whose market value is below your cost basis. The critical distinction is whether it stays there.
The natural question is: How do you know if a loss is temporary or permanent?
Many investors, especially beginners, hold onto losers because of the disposition and endowment effects and do not want to convert what had previously only felt like paper losses into realized losses.
This is a valuation question. If you understand why an asset was valued the way it was when you bought it and why it is valued the way it is now, then you are able to make a judgment on the relationship between price and value and how much that has changed.
Conversely, if you had no idea why it was priced the way it was when you bought it, how could you possibly know if it is priced correctly…ever?
Again, Buffett’s quote: Risk comes from not knowing what you are doing.
Categorizing the World
“Uncertainty, not risk, is the difficulty regularly before us. That is, we can identify the states of the world, but not their probabilities. Ignorance arises in a situation where some potential states of the world cannot be identified.”
— Richard Zeckhauser
Until this point, I have been using the word risk to include risk, uncertainty, and ignorance. We can now get a little more specific.
|States of the World||States of the World|
- RISK: Casino — Get your bell curve (normal distribution) out. The most predictable way in the world to win money, if you are the casino.
- UNCERTAINTY: Traffic — You know there will be traffic, but you cannot calculate how much.
- IGNORANCE: The effects of COVID-19 and US economy in 25 years — The state of the world is unknown and the probabilities are unknown.
Remember Person 1 above who asked what stocks to buy? Let’s say they went with the 40-year-buy-and-hold S&P 500 index strategy. Then, in 25 years, the United States has some combination of hyperinflation, cyber-attack, destruction of the power grid and general failure of the rule of law.
Clearly, we would have failed to meet our implicit goal of making money with the strategy we chose. But…we did not know what the state of the world was going to look like (we were ignorant of the future). Without getting too wonky, if you wanted to protect against these possibilities, theoretically you could buy farmland and develop the necessary survival skills. Again, these decisions are dependent on your philosophy.
The real world (outside of Vegas) is mostly us dealing with uncertainty and ignorance. When most people hear this, they are tempted to think: Oh good, we are all just relying on our gut instincts. I trust my gut.
Here is the world giving us another leaky valve.
Our gut instincts have kept us alive for a long time. This deceptive truth makes us overconfident in our intuition. All statements about the future are guesses, but not all guesses are equal.
When you have a bad feeling about a person, your intuition is probably right (and there are minimal consequences to getting away from that person and being wrong about him). When you have a good feeling about financial outcomes (ranging from uncertainty in financial markets to the lottery (probability and statistics)), your intuition is probably wrong.
Your gut is subject to many things including: memory (conveniently forgetting the times your gut was wrong), narrative fallacy (I am often guilty of this one), you telling yourself you were playing a different game…just to name a few. See The Black Swan for a full treatment.
What to Do With All of This
An expert in any field will have an advantage over a rookie. But neither the veteran nor the rookie can be sure what the next [card] will be. The veteran will just have a better guess.
— Annie Duke, professional poker player
If you are a professional investor, you already read all of the material public and non-public information you can get your hands on, to take advantage of the poor suckers waiting for Jim Cramer to tell them which stocks to buy.
If you are a non-professional investor with any meaningful exposure to an individual company, then a good habit to get in is to read Item 1A: RISK FACTORS in the 10-K of those companies.
However, regardless of whether you are an entrepreneur starting a lemonade stand, buying real estate, or about to pull the trigger on 10,000 shares of Amazon, doing the following things over a lifetime will likely improve your financial outcomes.
- Figure Out Your Philosophy Toward Risk. #3 will help you do this.
- Margin-of-Safety: The way to address an uncertain future is a margin-of-safety. If you want to drive 8,000 lb. cars over a bridge, you build a bridge that can hold 10,000 lb cars. Why would you do anything differently when buying assets?
This is the ONLY SHORTCUT in risk taking. The less you know, the greater your margin-of-safety needs to be.
- Decision Journal: Get a notebook and keep track of your important decisions.
Most people will never do this, so you can get a huge emotional advantage if you do.
Borrowing Daniel Kahneman’s advice to Michael Mauboussin: Whenever you make a consequential decision, specifically an investment decision, just take a moment to think, write down what you expect to happen, why you expect it to happen and then actually, and this is optional, but probably a great idea, is write down how you feel about the situation, both physically and emotionally. Just, how do you feel? I feel tired. I feel good, or this is really draining me. Whatever you think.
This prevents hindsight bias, which is no matter what happens, we tend to look back on our decision-making process, and we tilt it in a way that looks more favorable to us, right? So we have a bias to explain what has happened.
So, when you have a decision-making journal, it gives you accurate and honest feedback of what you were thinking at that time.
In times of stress, writing what you are feeling, thinking, and doing, will let you know what your real risk tolerance is.
- Beware of Monday Morning Quarterbacking (Distinguish between PROCESS VS. OUTCOME). Saying what you should have done is easy when you know what happened. The relevant question is, did you make the right decision given that you cannot know the future.
In other words, what should you do before you know the future? A classic example along the lines of: If you put $10,000 in Amazon in 1997, you would have a gajillion dollars. The natural question is: Well, since I can’t go back to 1997, where can I put $10,000 today to turn it into a gajillion dollars in 25 years? What is the next Amazon?
Sometimes a good thing can happen even though you made the wrong decision. People have a hard time with this one. If you only made one decision in your entire life, then your outcome is more important than your process. But, if you make a lot of decisions, your decision-making process is so important, it makes any single outcome irrelevant, except for those that cause you to blowup (see #8).
- Become an Encyclopedia (Know What You Are Doing). Gut instincts are the sum total of millions of experiences. Expert intuition ultimately comes from building up a lot of data points and being able to index and spot patterns from them. All knowledge in investing and finance is cumulative. Read and observe. Heavily discount when people say the only way to learn is by doing.
You can learn a lot from watching people jump off cliffs without having to jump off cliffs yourself. Ideally, we would run as many experiments as we could and learn about everything through trial and error (experience). The three big limitations are cost, time, and survival — sometimes, you only get one chance to run the experiment.
Yes, as Teddy Roosevelt would tell you, eventually you have to get in the arena.
- Become Antifragile. Put yourself in situations that benefit from randomness. For example, living in a big city around a lot of people puts you in a position to benefit from randomness.
Go to parties (instead of reading essays on risk).
- Read Marks’ 24 Types of Risk Before Making Financial Decisions.
- Survive (or Don’t Blowup). The best strategy is one that offers the highest compound return consistent with no risk of going broke. If you never put yourself in a position where you can lose everything, you can never go broke. This was Ed Thorp’s big idea in Blackjack. It is hard to lose if can never get knocked out of the game. As Taleb reminds us, what matters is not how often you are right, but how large your cumulative errors are.
One single loss can wipe out a decade of profits.
- Keep enough cash.
How Much Risk Do I Have?
You may be wondering: How much risk do I have right now? Obviously, that is impossible to answer definitively or quantitatively. But, a good place to start is figuring out where you are exposed to risk and seeing if you are in situations where favorable outcomes are much bigger than unfavorable ones (asymmetry).
In finance, three common and direct ways you control this is the game you choose to play, how much debt you have, and the price you pay for things.
- The Game You Are Playing: If you are an entrepreneur, then you have picked a risky game. Even within entrepreneurship, game selection entails a wide range of outcomes. Starting a restaurant requires more capital (money for leases, chairs, attractive hostesses, etc.) than software. If you work for someone else, that is also a risky game, but for different reasons. Notice the pattern?
- Debt: When you get debt involved, time becomes more important. You not only have obligations, but you have them at a certain time. Structured thoughtfully, debt can have enormous advantages. It also is the main cause of Blowing Up.
- Price: Through blood, sweat, and tears, you determine that Starbucks’ stock is worth $100 billion ($85.20 per share). You are much safer (and will earn a higher return) paying $50 billion ($42.60) for it than you are paying $99 billion ($84.35) for it…especially if you are wrong.
This is where your philosophy of risk and patience will come into play. Will you only buy it at prices that give you a sufficient margin-of-safety or will you buy it at any price you can get it as long as it is below what you think it is worth?