Deep Risk

I’m reading a fascinating book lately that has me thinking a lot about risk. (There will be a more in-depth discussion of said book at a later date.)

Risk is such a fascinating and tricky concept.

One problem with risk, is that by its very definition it is unpredictable.

What we usually try to do is to look at past destructive events, in order to estimate future risks.  But such an approach ignores the fact that the destructive events in question were entirely unpredictable when they happened.

(If we could have predicted the damage that the surprising events would go on to cause, then the events wouldn’t have been nearly so destructive in the first place.)

Furthermore when most surprising and destructive events happen, the magnitude of their destruction could not have been foreseen beforehand by back testing (Since the largest such events had, by definition never before been recorded.)

Put another way even the biggest economic calamities like the Great Depression, are only impressive because they were not surpassed by prior or subsequent economic crises.

So if we look back over 100 years of the American stock market and determine that in the worst recorded crisis an investor fully invested in the American stock market lost 75% of his portfolio value, this only tells us that it is possible to lose at least 75% of your net worth by investing in the American stock market. (It remains perfectly possible that you could lose 100% of your worth (or worse if using leverage) in some future event that will make the Great Depression look like a minor correction.

So it seems safe to assume that the greatest risk out there is one that we can’t see coming.

Furthermore risk is quite situation dependent. One person’s worst fear is another person’s greatest hope.

Even talking about investing in general, there can be multiple different ways of defining risk.

Volatility risk.

This is the risk represents the uncomfortable up-and-down movements of stock prices or commodity prices or bond prices.

Each time a price starts tumbling downwards and we see thousands (or millions) of dollars of our net worth disappear in a matter of days or weeks, we can’t help but imagine the negative trend continuing on forever (and it could.)

This is an uncomfortable thing. It is quite a different experience from, say, having your money sitting in a safe FDIC insured bank account (or even of simply using your money to buy something that you like.)

And beyond the psychological toll of volatility, volatility is destructive in and of itself. Consider the “low volatility anomaly.” In an efficient market model where investors are paid simply for taking risks, one would expect the portfolios of highly volatile stocks to outperform those of low volatility stocks. And yet historically portfolios of low volatility stocks have outperformed their higher volatility brethren on a risk adjusted basis.

(So even though volatility feels bad, at least it also destroys wealth!)

Underperformance risk

This is the flipside of volatility risk. If you decide that you cannot sleep at night with your money invested in volatile assets, and you put all of your savings in FDIC insured bank accounts, then the chief risk is that your money will slowly lose its buying power year after year as it does not keep up with inflation.

Although you will sleep well at night, your money will almost always shrink instead of grow, and it will become almost impossible for you to reach financial independence (unless you make, and save, an awful lot of money.)

Behavioral risk

This is probably the biggest risk of all for you, and me, and everyone else who invests. Our genetic makeup makes it likely that we will react in exactly the wrong way at exactly the wrong time.

Getting aggressive in order to claw back losses, and being overly conservative when it comes to collecting gains are exactly the wrong strategies when it comes to acquiring wealth. Unfortunately these are also the approaches that will feel most comfortable to us in most instances.

Probability wise, behavioral risk is a risk worth keeping in our consciousness at all times.

Hunter Pence’s diving-catch-tongue-position is an example of a  risky behavior.

In any case, thinking about deep risks has made me try to imagine the worst risks for each investing approach that I have personally considered adopting.

Buy-and-hold indexing.

The biggest risk here is that the underlying assumptions are false.

For instance what if the global economy and it’s underlying companies stop growing?

What if US t-bills stop being a risk-free asset?

What if there is a long downward trajectory of the market such that periodic rebalancing weakens an already weak portfolio over the course of years? (Something like the last two decades in Japan.)

(These risks will damage almost any portfolio, unless there is a minimum of equity risk incorporated into it (ie a permanent portfolio or a risk parity portfolio?))

Value investing.

What if the value premium has been arbitraged away?

What if the value premium doesn’t actually exist for retail investors?

What if there will be a unique economic stressor which disproportionally effects vulnerable companies (value companies) for a long stretch of time in the future?

Dual momentum investing.

What if there is a flash crash that concentrates the loss of the momentum portfolio’s value within one month (because of an increased equity exposure?) And what if the momentum strategy forces the investor to switch out of equities prior to a rapid recovery?

What if the momentum anomaly is arbitraged away?

What if there is a long period of whipsawing such that asset classes ping-pong between over performance and underperformance on a monthly basis, forever leaving the momentum investor in the wrong asset class at the wrong time?

What if short-term treasury/T-bills stop being a risk-free asset class?…

… And these are just worst-case scenario’s that I came up with off the top of my head. By definition there are much worse scenarios and I can’t even conceive of because I am trapped by my own empirical experience.

(Please add to the post in the comments section by helping me to imagine some new worst case scenarios, as well as some different investment strategies’ Achilles’ heels which you have considered. )

But the point here is that the future is unknowable, and even the most probablistic and best laid plans are subject to the whims of randomness.

So what are we left with***?

Not to beat that old drum, but it probably makes sense to just focus on the basics that we as individuals can actually control.

1. We should save more of our own money.
2. We should minimize our own investment costs.
3. We should choose an investment strategy that best matches our own personality and behavioral tendencies (it’s tough to go wrong with buy-and-hold indexing here). Such an approach will be the one that we will be more likely able to stick with through thick and thin.
4. We should play the probabilities as we best understand them.  (Long periods of backtesting are preferable to short ones.)

*** (Subtle cue for me to dispense the my own particular (and repetitive) brand of wisdom.  You can try to change the topic, but my wisdom is very robust and unchanging.  Inputs can vary but the output seldom does.)