Understanding Risk

Risk is the permanent loss of capital.

It is not volatility, nor is it uncertainty. It is the realization of a loss. Therefore, risk is hard to understand because it is only clear with hindsight that a loss has occurred. Understanding how risk works can avoid this permanent loss by avoiding the mistakes that cause the permanent loss of capital.

Risk can also be used advantageously. Knowing that there is the prospect of loss, planning, and investment strategies that profit from these losses put you on the right side of the equation. Risk can be used to an investor’s advantage.

Essentially, anti-fragile (to coin Naseem Taleb’s term) strategies can benefit from volatility, uncertainty, and loss. Randomness permeates all markets, which means risk is always present. Knowing that, investment strategies need to be able to withstand unpredictable or unforeseen stresses. Not all risk factors can be known, or even if potential risks are identified, the magnitude and timing are unknown. What can be certain is that they will occur, and a portfolio that is “fragile” can be devastated.

Effective risk management understands:

1. All investments are asymmetrical.

• An investment will either have more upside than downside, or the opposite. In other words, every investment can be plotted on an S-curve. Understanding where one is on the “S-curve is essential. Does this investment have a high upside with limited downside, or is the downside uncertain while it has a limited upside? Either scenario will be the case with EVERY investment.

• Avoid investments where the risk of loss is far greater than the value of profit, regardless of the profit potential – unless the profit potential is so great that the risk of losing the entire investment is still worth it. These are unique and rare speculations and are certainly not a general rule for any investment portfolio.

• All investments are curves, not lines. There is volatility and variability to upside and downside. Understanding whether or not the investment is potentially Convex (increases at an increasing rate) or Concave (decreases at a decreasing rate) must be known about every investment. Without this, risk is not understood.

• Past performance is not a good indicator of risk. The music stops eventually for many “attractive” investments.

• As the comedian, Steven Wright said, “I plan to live forever. So far so good.” We know the absurdity of this comment but miss its insight. Opportunities that seem to be going quite well will fail because the overall risk assumed by the investments involved is misunderstood. All we need do is look at the financial crisis of 2008 to understand that things that could not possibly go wrong will go wrong – often spectacularly.
  1. An excellent analogy is a turkey the day before Thanksgiving. He has been treated well and fed abundantly for 364 days. But his future prospects bear no relationship to past circumstances. Thanksgiving comes for the turkey just as the music stops for any exotic investment where “as long as the music is playing, we’re going to dance.”
  2. When the music stops, there are no chairs left. Fragile investment positions succeed, and sometimes thrive, until they don’t. Losses are never moderate and always outweigh the sum total of profits leading up to this point.

• Fragility, Robustness, and Antifragility.

1. Fragility. Every investment is fragile because it has the potential to lose. An unhedged position has the risk of a permanent loss, whether it’s from factors that are known (industry competition, technical superiority, or other competitive dimensions) and unknown (financial market crisis, economic recession, or depression). Volatility occurs in any given investment sphere, whether it is a disruptive high-growth technology company, an industrial sector, or an interest-rate sensitive security. Every investment is fragile.

• Robustness enables an investment to withstand most volatility. It can be a portfolio of securities that perform extremely well regardless of economic circumstances because there is enough margin of safety to the specific investment, or risks that could potentially undermine the value of that security have been hedged. The removal of risk is robust and enables survival, but it does not create profit from volatility or fragility.

• Anti-fragile positions profit from risk – known and unknown factors, whether it is hedging against significant market drops or other components of a financial crisis (financial crises are “those unpredictable events that occur every 7 to 10 years – so ought to be pretty predictable”).

An anti-fragile strategy was much more challenging to develop, however, interconnected and correlated markets have created a much greater opportunity to be anti-fragile. Previously uncorrelated assets are now directly correlated with market movements.

Computer trading, social media, and access to investment and trading apps have made market movements almost universal. This enables an effective anti-fragile strategy that hedges against market movements and “hot” investment strategies (the “flavor of the month” becomes distasteful quickly).

Anti-fragile benefits from risk, and risk permeates all aspects of every investment and is a permanent market characteristic.

Anti-fragile investment opportunities are abundant.

1. Randomness.

• The world is random, many specific outcomes are unpredictable, but collectively randomness creates an overall direction and understanding. Predicting specific events is extremely challenging, and almost impossible. But understanding general directions and movements (much like evolution) has a dimension of predictability. This understanding can develop thoughtful and intelligent investment strategies. Also, knowing the influences of randomness and the specific outcomes it can generate is also essential.

• Thus, investment success requires understanding asymmetry and the convex or concave characteristics of any investment. An investment with a limited downside (or one where the downside is clearly understood), but which has the potential for significantly large upside, combine to make an extremely attractive portfolio.

• Without identifying the specific big winner (because randomness is always present) we know that the combination is an attractive risk-adjusted return with the potential for significant upside.

• Randomness is generated by those without any downside risk, or “skin in the game.” Investment markets will be forever skewed and inefficient because regulators, policymakers, bankers, and other intermediaries have little to no downside. The markets will always be disproportionately influenced by those who have no consequences for their actions.

• False expertise influences markets disproportionately. Randomness and volatility will create winners simply through sheer chance. We only see the winners even if most people with the same strategies failed. Thus, markets are distorted by “successful” investment strategies that simply relied on randomness and chance, and these strategies are likely losers in the future.

• Investors typically look to “experts” to help guide investment decisions. This is increasingly influential via social media and other broad and pervasive communication platforms. It spreads disinformation wildly and will lead to even more market disruptions, randomness, volatility, and significant losses.

• Risk is going up substantially.

1. Black Swans

• Unpredictable and unforeseen events will occur. The insightful thinking behind understanding Black Swans is that they are predictable in so much as the fragile system we described will cause a negative Black Swan eventually. It will occur, and we know how to develop investment strategies to profit from the negative.

• We also know that with enough understanding of asymmetry and convexity, an investment strategy can profit substantially from a positive black swan.

• Randomness, fragility, volatility, asymmetry, and dramatic market movements are all predictable. Knowing when they will occur is beside the point. Knowing that they will occur enables a more effective risk-adjusted strategy.

• Effective investment strategy avoids the permanent loss of capital.