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Risk Explained

 Risk Explained

 

A Very Misunderstood Concept

Let’s start with a practical definition – risk is the degree to which a future thing is uncertain. So, for example what has greater risk: the sun rising or me eating a banana for breakfast tomorrow?

We can look backwards, as most people do, to observe there has never been a day when the sun did not rise, but I eat fewer than 50 bananas a year for breakfast. Clearly whether I eat a banana has greater “historical risk.”

Historical risk can be a very good indicator. In the case of the sun rising, we rely on physics to reduce our risk of being wrong. In the distant past, we believed a god in a chariot pulled the sun across the sky and the risk of no sunrise was thought to be much higher. What changed between our ancient selves and today – science.

Which brings us to another risk element: what has changed today that impacts risk tomorrow? In the case of science, we learned we live on a sphere that rotates around the sun and our risk the sun would not rise became more technical than hoping the chariot driver didn’t get sick that day. “Changing circumstances risk” is very important and far more elusive than historic risk because we are evaluating the degree to which “this time is different.”

We’ve all heard that history doesn’t repeat itself, but it sure does rhyme; and this impacts risk directly. To what degree do we believe this time is different enough that it no longer rhymes and why? In other words, the degree to which we nail “this time is different” directly impacts our ability to manage risk better.

 

“This Time is Different”, So What Do We Do Next?

A delicate yet obvious issue we can observe through a technology example. When the Internet burst upon the scene, people were right to think “this time is different”, but how and why? If we get the general idea right and the specifics wrong, we may be no better off than having the wrong idea altogether.

Following our Internet example, people correctly forecast big changes in the way we digest information, entertain ourselves and shop. What most people got wrong, however, was the idea that “we can value websites on visits over revenue and profits.” If I get the revolution right and bet on eyeballs over profits, I lose my money. Investors who still valued revenues and profits did far better with their Internet investments because companies like Amazon truly took off after they reached breakeven.

The Internet was different and if you had the details wrong, you probably lost a lot.

 

Some Opinions Are Better Than Others

We can see from the above that having the right opinion is the most valuable commodity when managing risk, so who has the best opinions on any specific risk? This is where it gets very hairy because the experts do not always hold the best opinions.

When it comes to understanding the traditions and logic of any particular company, industry or economy (all of which are important to assessing risk), experts long steeped in these issues tend to hold a significant edge. What they also tend to miss are disruptive changes on the horizon where people from outside the particular discipline may have an edge. I realize it seems completely contradictory and it also says a lot about how innovation arrives.

Without getting too deeply in the weeds, we generally observe that the more radical the innovation, the more likely it came from outside the industry. This is not an indictment of experts so much as our tendency to think in patterns.

Experts tend to adopt patterns that serve the traditional views. It also inhibits thinking too far “outside the box” as a distraction from elegant solutions. Thus, there are times when we want expert opinions and times when we need something more radical. How we tell the difference is very hard.

Let’s return to our Internet example before the world wide web arrived. In that world, AOL dominated the landscape with their free DVD’s mailed to every American. Through AOL’s worldview, they created a safe version of the Internet that meant we didn’t need a browser and we could not visit every site. They even went so far as to buy Time/Warner for exclusive content.

AOL’s expert opinion proved very wrong, Internet browsers are free and no one needs a software subscription to surf the web. Way back then, buying AOL appeared a much better bet than Microsoft who initially shunned the Internet as a distraction. As AOL made bets in a smaller edited Internet, other competitors adopted a wide-open service model (including a somewhat late Microsoft) and AOL died.

When we decide where our opinion lies, we should factor:

  • Whatare the traditional patterns;
  • Doesthe current world rhyme strongly with past situations that give us context;
  • Howtruly different is it this time; and
  • Dowe have the right

 

Opinions Spring from Many Sources

If we now agree risk is an opinion with varying degrees of accuracy, we are forewarned and forearmed to ask the difficult questions beyond anyone’s initial analysis.

I have never met anyone without any opinion, even if that opinion is that “This is not worth having an opinion.” We absorb opinions all day long from media, colleagues, friends and family without even consciously acknowledging these influences. It’s a daily stew of the insightful, silly and completely wrongheaded on a wide variety of topics.

What makes this especially dangerous is when we do not know much about an issue that sounds scary. When we feel anxious or scared, we look for reassurance that everything will be OK. Our desire to feel less anxious also leads us to accept completely false information when we lack the tools to know the difference.

If my kidney is failing and I have no medical background, I could more easily accept the wrong diagnosis and die. That’s an elevated risk I may try to reduce by asking for referrals, checking databases, etc. If the information is still wrong, conflicting or beyond my ability to digest, I’ve not improved my chances of survival. We need to bear in mind that opinions may sound reasonable or even downright insightful, and they may also be completely wrong.

 

Baseless Bank Runs

Before there was a Federal Deposit Insurance Corporation (FDIC), we suffered regular bank runs. A bank run typically starts as a rumor that such and such bank is low on cash. People then line up to withdraw all they have before the bank runs out of cash. The bank, because it lends money, never holds enough cash to pay every depositor in a single day, so any bank falling victim to rumors may actually have been fine in the first place. That it went out of business because a rumor spooked people to the wrong conclusion is just another example of self-fulfilling prophecy, or we sometimes create our own disasters.

 

Risk is Hard

Risk is all around us and we cannot completely avoid it. Where we truly suffer is deciding whether this time is different when big events hit us. Further complicating our lives, we also have to get the details right when this time truly is different or we may suffer as much as those who missed the change. Finally, if the event is big and scary enough, we are more willing to accept stupid answers to reduce our anxieties.

How then are we supposed manage investments sensibly? We are experts in companies, certain industries and financial analysis, and that serves us well when we see patterns we understand. What keeps us on our toes is whether “this time is different” and how that will likely unfold.

It’s not very hard to conclude that spreading our risk among the most probable outcomes will likely serve us well over time. How we perform over any specific time period will probably not look as exciting as riskier portfolios that got it right in that time; it’s also not the right way to view our service. We are a long-term proposition ready to support our clients when they need their cash cushion for expected and unexpected reasons.

Life UnLocked Partners, LLC is a Registered Investment Advisor (RIA) registered with the state of California, providing investment advisory services where registered or exempt from registration. Registration does not imply a certain level of skill or training. Investing involves risk, including potential loss of principal. Past performance is not indicative of future results. This material is for informational purposes only and does not constitute investment advice or a solicitation to buy or sell securities. For more information, please request our Form ADV or visit www.lifeunlocked.partners.