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What To Do About Risk Management

 

The thing about risk, is that there is uncertainty. By definition, anything other than 100% means we come up short by some measure and there is doubt whether we can make up the difference. Can we be sure of anything? Death and taxes are often cited. But in our world, is money in the bank or buying government debt really risk free? As history has shown us, this is most certainly not the case. With many thousands of bank-runs or governments that overspent and were unable to pay back their debts, the track record for a 'sure thing' isn’t very good. 

 

This is why when people talk about the 'risk-free' rate, it really does make me chuckle. There is always risk, there has to be. It may be very small but it’s there and, as 2008 showed us, anything is possible however improbable. 

 

So now that we understand that in everything we do there is an element of risk, we should also lose our fear that something might go wrong. Something will always go wrong, that’s life and literally we have to live with it. That being the case, why not enjoy ourselves, for the very act of taking risk gets rewarded in the world of investing. They are called 'risk premiums', and they have a wonderful way of bestowing riches for those that have taken the decision to let the probabilities play themselves out.

 

There is no good and there is no bad risk, there is only unrewarded risk. Think of it this way: markets may not be efficient in the short term but they are pretty close, as there are many very smart people with amazing technology and unlimited amounts of capital scouring the markets for mispricings. Which is why there aren’t a lot of risk free trades that make 10% out there. But it also means that the risk we take will more than likely also not be mispriced as, for the most part, we buy at market prices. We don’t see a BMW for £30,000 at the dealership and for £10 at Aldi, do we? So, the only way that we can lose out on taking risk is if we pay too much in costs and fees to make our investment.

 

So how do we measure risk? Well grasshopper, that is a whole other discussion. Ultimately, we are dealing with the unknown, and the question becomes how do you model randomness? Modern financial theory is entrenched in using mathematics, statistical algorithms and even behavioural models to quantify risk. It really comes down to how we assign probabilities to future events, using historical data. And therein also lies the limitations of any such models, it is just statistics based on stuff that happened in the past. In a previous post, we discussed that using one’s gut and natural inclination to risk (Size of Bet Revisited) may be another alternative to quantifying risk. In combination with the assurance of any risk management model that uses sound data analysis, that should prove a very good system.

 

My preferred method, however, is even simpler. I look at any investment according to two parameters: what is my expected loss in a normal scenario and what is my worst-case loss if the s*it hits the fan? This requires a great deal of honesty with oneself, because usually we try to talk our way into an investment by concentrating on the expected returns. After all, why else do an investment if we are not excited about making money? But, stepping back and looking at things from the viewpoint of everything going wrong opens up a whole new perspective in putting together portfolios and comparing investments across these simple variables.

 

No risk, no reward. But don’t let the excitement of being free to indulge in taking risk make you subject to the greatest fallacy of all: never bet thy whole wad.

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