In the world of finance and investing, risk is often oversimplified as volatility, or fluctuations in portfolio value over time.
This narrow definition fails to capture the multifaceted nature of risk and its impact on our lives and decisions. When you think about genuinely feeling secure in your financial future and strategy, do you really think this comes down only to the volatility of your stock and bond portfolio?
If you're like most people I talk to, the answer is "actually, not at all."
So, let's take a look at the other major factors and thought processes that may help bridge that gap.
How to Think About Risk: Thinking Tools, What's Misunderstood, and What's Impactful
Consider Your Real Sample Size - NFL vs MLB
One of the most crucial distinctions when it comes to risk is between situations in which probability applies pretty well over many applications, and those situations with very few repetitions or, in many cases, the "sample size of one." Probability-based thinking works well in scenarios with large sample sizes, where you're going to get a lot of shots-on-goal or flips of the coin, and the outliers will work themselves toward the average over time.
Applying that same thinking to situations that produce just one outcome over a long period of time, instead of many times in succession, can be dangerous. A single coin flip doesn't come up 50% heads, 50% tails. It comes up 100% heads or 100% tails, and you can't predict which. You need to be prepared for either heads or tails, not half of both.
I often think about the narrative that the NFL was slow to adopt advanced statistics and analytics because NFL coaches and front offices were "old school" or conservative. But I think there's another, totally reasonable explanation. The MLB, unlike the NFL, has a season with 162 games per team. Each game has at least 27 outs to contend with, many more at-bats than that, and well over 100 pitches per team per game. In that environment, certain kinds of probabilistic decisions have a chance to play out tens of thousands of times in a single season. You may be wrong playing the odds any one time, but it's ok - you're going to get many, many more at-bats, and doing the statistically right thing over time will likely work out for you.
Contrast this, now, with the NFL. The NFL only has a 16 or 17 game season. Likely scoring plays are fewer and further between. A single loss on a high probability bet that didn't go your way and results in a loss can actually have a meaningful impact on your entire season. For a pivotal play in the Super Bowl (which, in turn, is one game, not one of 7 in a series), it's no consolation to do something that should have worked out 55% of the time. Some of those players will never play in another Super Bowl. The coach may never get even a second attempt to see it work out "on average."
It makes sense to avoid failure in those situations and only do things that (1) make sense in the one specific context in front of you, not in most contexts on average and (2) that if they don't work out, give you more options to proceed and don't result in immediate failure.
Many of life's most important decisions are one-off events—you only get one shot. Just as statistical applications are less reliable in the NFL, we can't base our most significant choices on probabilities alone.
Expected Value: An Incomplete Picture
Another common way to evaluate risk is through "expected value" calculations, which weigh potential outcomes by their likelihood of occurring. While useful, expected value metrics provide an incomplete picture, as they fail to account for the subjective impact of extreme, but possible, outcomes.
In financial planning, the key question is not just the expected value but whether you can tolerate the downside outcome(s), however rare they might be. For example, although the likelihood of a house fire is low, the potential loss is catastrophic, making home insurance a necessary consideration. It doesn't exactly matter if the expected value of paying for home insurance is positive or negative vs the expected value of being uninsured and having a house fire. You do it anyway, because you aren't dealing with a marginal expected value decision, you're dealing with a potential catastrophe that risks ruin if you're unlucky.
Understanding the drivers of both value and true tolerance for edge-case risk helps in making informed decisions, ensuring diversity and flexibility in your approach.
Downside Risk and Concentration
In my view, downside risk and exposure to concentrated risks are among the most underappreciated forms of risk. Many people fixate on volatility while overlooking the potential for disastrous outcomes or failing to diversify properly. It's crucial to ask yourself, "Can I tolerate the downside case, even if it's rare? What would it cost to avoid it?" This mindset shift can lead to more robust decision-making.
A study of MSCI data from January 1987 through February 2023* found that over the 36-year period, 42% of the stocks in the Russell 3000 went down by at least 50% and never recovered. A lot of people I talk to have gotten used to the now well-publicized idea to stay the course, that stocks in general tend to recover after declines, and that downside risk is temporary. That's basically true in the history of US markets, but it can be painfully easily to mis-translate that truth of the broad market to also be true of single stocks, or a business you own or work for. It isn't. Sometimes things just go down, and they don't come back.
*Source: Aperio, MSCI. Data from January 1987 through February 2023. Never recovered is defined as the stock remaining below the 50% impairment level in price.
Novel Outcomes & The Importance of Understanding Conditions Behind a Trend: Bertrand Russel's Inductivist Turkey
To understand how important it is not to extrapolate too strictly from past observations, and to understand how those past results came to be, I think it's best to point to the example of Bertrand Russel's chicken/turkey:
In a variation from Russell's original, a turkey designated for Thanksgiving is fed and cared for every day until it is slaughtered. With each feeding, its certainty or confidence that nothing will happen to it increases, based on past experience.
From the turkey's point of view, the certainty that it will be fed and cared for again the next day is greatest on the night before it dies, of all days. Nevertheless, it is slaughtered that day, by the very person who cared for him.
The slaughter comes as a complete surprise to the turkey, who..."only extrapolates a trend" and "does not recognize the impending trend break". To recognize this trend break, the turkey would have had to find out the causes of the trend.**
** Source: Turkey illusion - Wikipedia
The Recency Trap
Another common pitfall is falling victim to the "recency trap," where we perceive recent events as more representative of the future than they likely are. This inverse relationship to mean reversion can cause us to underestimate risk when times are good and overestimate it when conditions are poor. Maintaining a historical perspective and understanding the drivers of value and risk can help counteract this bias.
"Reversion to the mean" generally refers to a tendency for things that have shown performance above well-established historical averages will tend to perform below those averages in the future, resolving to somewhere around the originally observed average. Of course, this isn't a rule, but a theory and a concept, and predicting returns is generally a fool's errand. Still it's useful to consider that while it's tempting to look at what's done well for the past 10 years and simply assume those are the best things, in fact they may be exactly the things that are primed for a reversion.
Embracing Complexity
The tendency to adopt simplistic definitions of risk stems from the desire for scalable, cookie-cutter solutions. This approach often leads to managing probabilities without truly understanding the underlying complexities. Many disagreements about risk boil down to differing definitions and assumptions. Effective planning requires a nuanced understanding of risk, considering both positioning and fail-safes, and employing a robust decision-making matrix. Different situations and decisions may require considering various forms of risk, including novel outcomes, catastrophic risks, personal risks, risks to cash and liquidity, concentration risks, and many more.
Embracing this complexity, rather than glossing over it, is crucial for effective risk management.
It's often easier, in the role of strategic planner, to just give the simplest answer that applies in the most cases. My team considers that kind of approach to be a disservice and is willing to put up with the potential discomfort of presenting complex solutions that actually consider the depth involved in each client's individual case. No one is aching to take more time to come up with a plan that's harder to implement - that's not the point. The point is that if the situation calls for more thoughtful work and difficult solutions, then that's what's appropriate. No less.
Repeated Actions vs. One-Off Decisions, and Opportunity Risk
Understanding the difference between decisions that multiply and those that are one-off is crucial.
Repeated actions, such as systematic investing or saving and tax-loss harvesting, have compounding effects, while one-off decisions, like a single purchase or short-term decision may just serve as shiny distractions in their proper long-term context. Other types of decisions, like career moves or other hard-to-reverse major purchases or risk exposures, may require careful consideration when they reach a size where they'll have lasting impact.
A related idea is to focus on what can grow exponentially vs what changes linearly. Expenses can be cut by percentage points, and they may stay down, and they may creep back up, but "zero" is the lower limit, and no one will ever get there in practice. Thus, there can be limited utility in focusing on things that can't repeat or compound.
Income, on the other hand, has no (theoretical) upper limit, and pursuing higher income can yield a completely different level of results in a person's life. But how many of us have spent hours trying to save $50 on a flight or purchase one-time? How else could those hours have been spent to produce more meaningful outcomes? There's a level of opportunity risk to almost everything we do.
All of this boils down to prioritization. Simple answers often show up where maybe they don't belong. Hugely consequential, irreversible decisions are where your focus and resources should go, but some try to check this box with niceties, avoidance, and denial to make time to hover over minutia elsewhere, in areas more easily reversible or less consequential, simply because it's easier.
Planning in an Uncertain World
First Principles Thinking
Reasoning from first principles involves questioning the status quo and designing solutions from scratch. This approach emphasizes understanding fundamental objectives and the simplest path to achieve them, rather than relying on standard answers.
It allows for more robust and adaptable solutions, avoiding the pitfalls of generic advice. In both personal and business contexts, first principles thinking fosters innovation and resilience, ensuring decisions are well-grounded and adaptable to changing circumstances.
This, to me, is the foundation of tackling risk management. What is worth avoiding, and what is tolerable? What are all of the tradeoffs? What are all of the options, and how can the downside of one decision potentially be offset by another decision? These answers, unfortunately, don't come from Google's results for the most common answers.
So, how can we plan and make decisions in an environment where risk has many definitions? Here are a few strategies:
- Positioning: Adopt a flexible, diversified approach that positions you to weather different risk scenarios.
- Redundancy: Build in redundancies and backup plans to mitigate the impact of unexpected events.
- Decision Matrix: Develop a framework for evaluating decisions based on their importance, reversibility, and potential consequences.
Critical Questions for Risk Management
To navigate the complexities of risk, it's vital to ask the right questions:
- "What if I'm wrong?": This encourages playing out hypotheticals without getting bogged down in them, balancing psychological comfort with realistic planning. It's ok to have a well-reasoned view of what's likely to happen. But it's important to know exactly what you'll do if what you thought was going to happen, doesn't.
- "Is this important to me?": Evaluating personal values and objectives ensures that financial decisions align with what truly matters to you.
- "Does this need to be true, or does it just tend to be true?": Differentiating between necessary truths and general tendencies helps in making more informed decisions. In finance especially, tendencies tend to get confused with laws of nature all-too-easily. What you've seen historically is not a promise of what's to come.
Ultimately, the most impactful step is to cultivate a mindset of continuous questioning and re-evaluation. Ask yourself, "What if I'm wrong?" and play out hypothetical scenarios. "What if?" is not the end of a line of inquiry, it's the beginning. You may know what you think is going to happen, but can you tolerate what it means if what's likely to happen, in fact, doesn't? Interrogate your assumptions and priorities, and don't shy away from complexity.
Risk is an unavoidable part of life, but by expanding our understanding beyond narrow definitions, we can make more informed choices and better navigate an uncertain world.
2024-177082 Exp 06/26