Most discussions around investments centre around returns and very little on the risk associated with those returns. Perhaps, expectedly so, given risk isn’t particularly easy to understand. But we can’t ignore it either given it is all around us even beyond the world of investing. Luckily we have had some really good writers help us understand risk, most famously Nassim Nicholas Taleb in his books which feature uncertainty as the central topic. In recent years, Morgan Housel through his story telling has further simplified our understanding of risk. Here’s a piece by Ben Carlson on similar lines, that help drive home the point that why and how we should be prepared for the unpredictable.
“Risk is a complicated topic.
It’s hard to define. It’s impossible to eliminate. And our perception of risk can often have unintended consequences.
When things feel safer, we can let our guards down, which actually increases risk in many activities.
Last year roads were far less congested because people weren’t traveling as much due to the pandemic. Yet U.S. traffic deaths were at a 13 year high, up 7% from the year before.
How could this be?
Roads were less congested so people took more risks by speeding, failing to wear their seatbelt or driving under the influence. The roads were “safer” but people took that safety to mean they could take even more risk….
…Risk can also be context-dependent and depends on your time horizon.
Stocks are risky in the short-term but it’s even riskier if you don’t hold them in the long-term. Cash is risky in the long-term but it’s even riskier if you don’t have liquidity in the short-term when you need to spend your money.
So how are people supposed to survive in a world in which:
- Risk perceptions are constantly changing
- Safety is often an illusion since risk never completely goes away
- Base rates can be helpful but also hold you back
- We know bad things can and will happen
Understand normal accidents are inevitable. In Normal Accidents, Charles Perrow describes the risk inherent in any complex adaptive system:
As systems grow in size and in the number of diverse functions they serve, and are but to function in ever more hostile environments, increasing their ties to other systems, they experience more and more incomprehensible or unexpected interactions. They become more vulnerable to unavoidable system accidents.
These normal accidents occur in the stock market all the time.
For instance, I know my investment lifecycle over the next 4-5 decades will be littered with recessions, corrections, bear markets and brutal market crashes. This is a feature, not a bug of our economic system.
I will likely see my stock holdings fall 40-60% a handful of times, 20-40% every 4-5 years and 10-20% every couple of years or so. Any money I have in the market will be incinerated multiple times in the decades ahead. I don’t know when and I don’t know why but I am confident this is going to happen.
But that doesn’t mean I’m going to sell all of my stocks. I just have to build an investment plan that accounts for the inevitable downturns.
You can’t predict but you can prepare. When they were testing the prototype for their first powered airplane, the Wright Brothers would always bring extra materials with them for every test run.
They knew they would inevitably have issues but didn’t necessarily know what would go wrong ahead of time. So they brought all sorts of different tools and parts just in case.1
Contingency planning is a staple of risk management because life never goes according to your original plan.
Learn to live with uncertainty. Peter Bernstein once wrote, “The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.”
Managing risk boils down to controlling what you can control and understanding some outcomes are out of your hands.
Almost every decision you make comes down to looking at all the alternatives and choosing the route with the highest odds of success.
Unfortunately, the whole point of risk is we don’t know what’s going to happen.”
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