Naive Investor Prelude to Chapter 8: A New Dichotomy of Risk

Before embarking on asset classes I will condescendingly call 'real securities' namely stocks and bonds, I feel it is time to elaborate on risk one of the central concepts of investment if not of our time.

If you look up Risk on wikipedia you'll find a fairly fair assesment of risk having all types of definitions depending on context. You'll also see an allusion to the current debate surrounding risk.

I'm going to simplify it for you and catagorize risk by the two general approaches to it one of which I am in favor of, one I am strongly against.

Let me introduce the two approaches 'CYA' and 'Consequentialist'. Now I shall elaborate.

CYA:

CYA if you are unfamiliar stands for 'cover your arse' and it incompasses pretty much all of the current popular investment risk strategies. Portfolio theory that is taught in university, Gaussian probabilities etc.
It is largely statistical based and measures the volatility of outcomes over time. CYA is largely attributing probabilities to possible outcomes and focuses on the downside of risk, that is avoidance of losses not so much the seeking of gains.

CYA conforms to 'expected value' which in lay terms is given by expected value = chance of success x value of success. But it focuses if you will on chance side of that equation. So if you have a 50:50 chance of winning $1 million dollars (with the alternate outcome being 0) your expected value is $500,000 thus, it is perfectly rational to bet $499,999 on a 50:50 chance to win a million dollars.

Perhaps the CYA approach(es) are best summarised by wisdom teeth. My wisdom teeth. X-rays of my lower wisdom teeth revealed that like my other teeth they had very long roots and unlike my other teeth these roots wrapped around the nerves that control my lower lip. Thus in time they could actually sever the nerve and leave me drooling for the rest of my life. Removing them involved some risk too. So the dental surgeon consulting me pointed to a sheet saying that if I didn't have the surgery a had a 30% chance of living in drooltown, but if I had the surgery and something went wrong I had a 5% chance of drooltown.

Here I could compare the risks directly, and gave informed consent for the operation. It was an operation I only had to have once and 19 times out of 20 I'd wake up afterwards and have a fully functioning lower lip.

I call it CYA because the primary function of calculating the risks is to cover the surgeon in this case from litigation. Nobody really anticipates waking up in the worst case scenario even with the ambiguities of the assumptions I based my decisions on, like 'how qualified is qualified?' when I assumed he was a qualified dental surgeon. If I had been sitting in a local clinic in rural Pakistan and been presented with the same form chances are I wouldn't sign it, factoring in additional risks to the proposed 5% like a 50% chance I didn't wake up with my kidneys.

Anyway, CYA is fine for doctors, because the benefits to society of a Doctor practicing within the limits of his training outweigh the downside of the occasional fuck-up, so people shouldn't be allowed to sue them out of business and practice every time there are complications. This is distinct from actual medical malpractice.

CYA is not so great for an investment firm. Because you aren't having surgery every day you do either passively or actively make investment decisions again and again every day. So when a financial advisor, broker or ratings agency tells you something probably wont happen they are winking at you and covering their arses.

And cover their arses it does, nobody yet has been clapped in shackles and been transported off to jail for the US-subrime crisis. Just like a doctor they tell you the probability of some catastrophic result is 5%, and that 19 out of 20 years your investment is going to flourish. But you don't invest for a year (hopefully) you invest every day and once every decade or so that catostrophic outcome occurs and you lose 30% of your net worth.

When you demand somebodies head for not warning you of this impending danger you find you can't. You interpreted their advice as 'don't worry it won't happen.' when they said 'don't worry it probably won't happen.'

There in lies the main philosophy of what I call CYA risk management they tell you 'don't worry it probably won't happen' and lure you the naive investor into taking risks. If your wager goes sour they hold their hands up and say 'hey, we said probably.'

You can spot CYA because they attempt to predict future volatility by past volatility. So they determine their probabilities based on past price movements and relative price movements. They believe that something is safe because 96% of all error terms fall within 2 standard deviations and shit. All whilst blithely ignoring the (relatively) regular occurances of 10 sigma (standard deviation) shifts that should only happen once in a trillion years (aka, market crashes).

Consequentialist:

So I mentioned the expected value equation. CYA focuses on the element of chance, or chance variable. Consequentialist looks to either side and below. Put simply, what are the consequences?

It takes almost Zarathustran unlearning to admit you don't know something, so let's first address why I and the consequentialist approach largely leave to the side or disregard entirely the chance element.

There IS a clear cut dichotomy when it comes to knowledge, you are either A) certain. Or B) uncertain. There is no inbetween. If you have 50:50 or 95:5 distribution of outcomes you cannot say the former is uncertain and the latter is certain, fairly certain or even almost certain. Why? Can you rely on any outcome in either situation? No. At the end of the day, you don't know what is going to happen. Whereever you permit the thinnest sliver of doubt, you simply cannot count on everything going your way.

Sure you can hope that it does. You can pray that it does. You can wish that it does. But you cannot rightly, expect it to, or count on it to.

You shouldn't base your decisions on the probability. You should base them on the consequences of the outcomes.

It is for this reason, we invest little energy or effort into estimating the probabilities. They can be good to know, but they are afterthought status. The only exception would be in a casino where the randomization is mechanical and predictable in which case you don't bet and certainly don't bet for long periods because the house always wins.

So we look at the consequences. If we want to be thorough we look at both positive and negative outcomes. Being conservative though, I would suggest looking at the negative outcome.

In CYA we determined that it was rational to wager $499,999 on a 50:50 bet for $1 million. This probably wasn't too convincing for you. From your perspective, the prospect of (barely more than) doubling your wealth isn't nearly so attractive as the horrifying prospect of losing your wealth. A consequentialist approach is simply - you cannot bare the consequences of losing.

There is your decision rule 'can I accept the worst outcome?' or if you will 'Am I happy to lose my money?' here, the term happy is ambiguous. If you are like me and plan to invest ethically, your view may be slightly skewed, it may be that you are happy to lose your money on ethical investments because consistent with your values there simply is nothing else to invest in. But for most people it will mean 'can I honestly say that if the deal goes south and my money is gone I will suck it up? That I will tell my friends "I made my own bed now I'll lay in it"?' and so forth.

Warren Buffet appears to take this approach, and I suspect you'll find it in many of the value-based investors. To paraphrase Buffet 'I'd never bet something important to me to gain something unimportant.'

Buffet's situation is no doubt a positive one, based on the philosophy of 'You only get rich once' which to put it simply says, once you are rich there is not too much point to being double rich. So why bet your financial freedom (being rich) to just get wealthier?

Now for those scratching their heads and wondering why anyone would ever make any wager, let's rephrase slightly, the real statement is 'what can you afford to wager?' Where naive investors get in trouble is wagering everything they have so they become risk averse and apply the same level of risk to their whole portfolio even when it is called 'diversification'

For a billionaire the answer to the aforementioned question may be 'I can afford to lose $100,000 every year.' they know their savings are enough to mitigate any loss's impact on their lifestyle, and their savings ratio is sufficient that they will replace the lost principle in short order. They can shop around for the highest expected value, accepting either a low risk, large return or a high risk extremely large return.

For you, that figure is going to be smaller, and the 'fat-tails' approach may not be for you. But the question is still valid, how much could you lose without inducing panic? Without seriously crippling your future lifestyle ambitions? furthermore it doesn't stop there. The true consequentialist approach mitigates the consequences by coming up with contingencies or taking out insurance.

You can do this with derivatives, forward contracts, hedging etc. You can just adjust your lifestyle expectations. Your 6 month holiday in Europe would be nice, but if things go south (way south) you'll just go to touring round Australia, Central America etc.

Consequentialism in other words throws out the fallacy of the slippery slope by actively thinking through the actual consequences rather than banking on them not happening. What I mean by slippery slope is when mentally you think of your options being A and Z instead of A to Z.

For example, my mother is pathologically afraid of ending up in a shitty flat in a retirement village to live out the rest of her days on a Aged Pension. This is option Z. What she wants to do is take 3 month holidays to Europe and so fourth for the rest of her years travelling and living up retirement. This is option A.

She is prone to panic because her super funds and investment portfolio seem to be pointing at either option A or option Z at any given time. What she fails to acknowledge is the vast range of lifestyle options and outcomes between the two extremes. Option B for example maybe 2 month annual holidays to Europe. Option M might be annual caravan trips around Australia. Option J may be volunteer work in Africa somewhere. Option X maybe living on the aged pension in rural Indonesia... by concentrating on consequences, you can actively change your risk profile.

To contrast CYA we know says 'Don't worry it (probably) won't happen' then the Consequentialist says 'You will recover (with dignity) if it does happen.'