I’d like to ask you something: What is risk?
That sounds like a stupid question, I know.
But consider this. Your definition of the word “risk” and the definition used by the financial industry serving you is completely different. And the gap is the source of rather a lot of anguish, if you ask me.
Risk, in its simplest form – the dictionary definition – is the chance of something going wrong. That’s what most of us mean when we mention “risk”.
But did you know that, in the financial industry, it’s also the chance of something going right? They see risk as a sort of probability measure. Back to that below.
Going way back, we may have simply thought about risk in its simplest form. The chance of a bad event. But, over time, our understanding has evolved. For good and for ill. Today, we dig into both sides of the coin. And explain why the distinction matters to you.
A world without risk is stagnant
In his book, Against the Gods: The Remarkable Story of Risk, Peter Bernstein sees risk-taking as the driving force behind the evolution of our entire species. Again, that sounds silly given the definition of risk. But if you think about it, that is not an outlandish idea…
It was quite a risk to leave your cave and hunt for some bearskin to keep you warm at night. But we did it anyway. And, once we figured that out, it became clear that, if we (as a species) wanted something better for ourselves or our nations… it came at a potential cost. In other words, it came with risk.
The revolutionary idea that defines the boundary between modern times and the past is a mastery of risk… until human beings found a way to cross that boundary, the future was a mirror of the past or the murky domain of oracles and soothsayers who held a monopoly over knowledge of anticipated events.
The idea that risk is a matter of chance, as opposed to a decision by the gods, enabled us to think more clearly about whether to take risks. And choose which ones were worth taking.
Although the future is unknown, there can be enormous and lasting rewards for taking a chance on favourable outcomes. That’s the first key realisation. That risk and reward are somehow related.
And this is a powerful and potentially transformative idea in our financial lives, too. It’s one of the first and only useful things you’d learn in a university finance degree – the relationship between risk and reward.
Gamification of risk
Our modern understanding of risk comes from scientific insights about gambling and games. Betting odds, in effect.
Statisticians and philosophers derived rules and axioms about our world based on these games.
What is the probability of tossing heads three times in a row? If a game of cards is interrupted by the King of France summoning one of the players, how should the stakes be divided between players in a fair way given how the game has unfolded so far? And then there’s the infamous “Two Child Problem”. Don’t go down that rabbit hole…
Many of the axioms discovered in such ways still have a huge influence today. They’re used in financial markets.
One key insight is that it’s not just about probabilities. It’s also about outcomes.
Betting on the favourite in a horse race is likely unwise because the payoff will be smaller too. For the bookies to win, the odds always have to be slightly smaller than what would be worth making the bet at. So, the outcome doesn’t pay enough to make it worth taking the risk. Unless you have some inside information… which is why that’s what all the racecourse drama is really all about.
One of financial guru Nicholas Nassim Taleb’s many books on the subject of risk is about the importance of the outcome. You don’t expect your home to be swept away in a flood. But you buy insurance nevertheless… because the outcome is so large and so impactful.
In the book, Taleb recalls a regular meeting where each trader at the investment firm was asked whether they thought stocks would go up or down and why. When Taleb said “up”, one of his colleagues burst out “but you told me you were short”, meaning Taleb had bet on markets falling that day.
The two seem contradictory, but they’re not. Taleb replied by explaining that the market was more likely to go up, but if it did go down, it would go down a lot further than it would go up. Once you factor in the size of the move, not just the direction, it made more sense to be short.
What made Taleb so successful was his willingness to be wrong most of the time, but when he was right, his winnings were big enough to outweigh the losses. He founded a firm largely based on this principle. It’s the opposite of picking up pennies in front of a bulldozer. But not many financial professionals can wait as long as Taleb is willing to.
The fact that Wall Street traders didn’t intuitively get this idea is important to you and me, as regular investors.
In a past edition of Fortune & Freedom, we looked at counterparty risk. That isn’t mentioned by the financial services industry much. But, based on your emails, it’s a rather large problem for many of you…
How many of those invested in Neil Woodford’s fund would’ve done so if they had been told an accurate level of probability that his fund would be gated?
Let’s not answer that one…
Another of Taleb’s books is about outcomes which we simply weren’t able to understand with probabilities in advance. They’re known as Black Swans because we just can’t even conceive of them until they happen in front of our eyes. The inconceivable is hard to assign a probability to. And yet, if we acknowledge that inconceivable things do happen, that really makes thinking about all this interesting.
Our former Bank of England governor, Mervyn King, whose book Radical Uncertainty inspired some of today’s editorial, explained a similar idea like this:
We picked [the title for our book] because so much uncertainty, in the world of economics, people are desperate to quantify it. And our view of radical uncertainty is that it’s uncertainty that you cannot easily quantify.
I mean, the best example, I think is what we’re going through now, COVID-19, in which we knew, well before it happened, that there could be things called pandemics. And, indeed, we say in the book that it was likely that we should expect to be hit by an epidemic of an infectious disease resulting from a virus that doesn’t yet exist.
But, the whole point of that was not to pretend that we, in any sense, could predict when it would happen, but the opposite. To say that: the fact that you knew that pandemics could occur did not mean that you could say there was a probability of 20% or 50% or any other number that there would be a virus coming out of Wuhan in China in December 2019.
Most uncertainty is of that kind. It’s things where you know something, but not enough and certainly not enough to pretend that you can quantify the probability that the event will occur.
That’s where finance went wrong. Not just the presumption that something bad wouldn’t happen. Not just mismeasuring its probability. But turning risk into a game. In the sense that, we can understand games, so let’s pretend risk and financial markets behave like one. Then we can pretend we know what’s coming in the future, because we can quantify it mathematically. A bit like a coin-tossing game.
This presumption is what caused much of 2008’s crisis. The presumption that financial markets were a game which conformed to the statistical axioms derived many years ago from games. Those axioms included bell curves without fat tails, meaning rare events are too rare to worry about.
But then such a rare event struck. Something that wasn’t within the rules of the game as the measures of risk had defined them. US house prices fell. And global financial markets went haywire because this possibility wasn’t included in their models.
Why not? Answering that question helps illuminate the point I’m trying to make.
Nobody predicted this
Do you remember hearing about how “nobody predicted the financial crisis”? Well, consider this interview segment from 2005, when Federal Reserve chairman Ben Bernanke was asked about US house prices on a financial news show:
Interviewer: Sir, we have so many economists coming on our air and saying, “Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.” Some say it could even cause a recession at some point. What is the worst-case scenario, if in fact we were to see prices come down substantially across the country?
Bernanke: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis.
Turns out, not only were we warned. But by “many economists” who went “on air”. But the Federal Reserve chair didn’t buy their premise because it hadn’t happened before. Under modern economics’ theories, that’s a measure of the risk of it happening. And by that game-style measurement of risk, it can’t happen.
Until it does…
When 2008 did happen, some people inside the industry were mystified – another key fact you should bear in mind. Even after the event, there was confusion in a lot of quarters.
Some risk analysts believed their models of risk were correct, but that an incredibly rare event had happened, instead of believing their models were wrong. They forgot the true nature of risk – the probability of something really bad happening.
We made all these mistakes despite the insights of people like Mervyn King and Nassim Taleb.
Then again, their books were published with the benefit of hindsight. But at least both were on the front lines at the time of crisis…
One of the Bank of England’s original purposes was of course to help the British banking system through the sorts of market panics which they hadn’t really foreseen and so weren’t protected from. It’s a little older than the US Federal Reserve. Perhaps that’s why King’s perception was a little different to Bernanke’s…
Science isn’t perfect, but it’s better than nothing, right?
Consider what King’s interviewer asked him…
Russ Roberts: On the surface, you could argue–and some do–that, ‘Well, this is just part of science. It is imprecise, but we’re getting better.’ Mervyn, what’s the danger of making that kind of precision on the grounds of it’s just doing the best we can?
Mervyn King:It’s not doing the best we can. It’s pretending that we know more than, in fact, we do.
And, there is a real danger in that. If you pretend to know a great deal more than, in fact, you do know, what you’re going to be doing is making judgments and decisions based on the false assumption that this is what would happen if you take one particular action rather than another.
And I think that deflects from what we in the book describe as the most important thing to do when confronted with a decision under uncertainty, which is to ask the very simple question : What is going on here? Because that is a way of actually getting to the bottom of what is happening.
Asking “what is going on here?” – the theme of King’s book – is part of what we try to do at Fortune & Freedom.
If you ask yourself that question when you play Monopoly with my little sister, you will find it surprisingly easy to predict what happens next. If you consult the rules of the game, you’re in for a surprise…
The good news is that the financial industry can sometimes take time to learn their lesson. Some parts continue to use models which quantify risk based on what happened in the past instead of wondering what’s really going on in the economy and financial market.
The ironically named Long-Term Capital Management blew up in 1998 when financial markets failed to conform to academic models of risk – the warning that Wall Street should have needed about a decade later, in 2008. The tech bubble of 2000 is back today, if you ask me. And risky European debt is still highly rated by credit ratings agencies, based on my analysis.
All this gives us an edge, if we keep asking “what is going on here?”
And so that’s what we’ll do at Fortune & Freedom.
Doing so brings up all sorts of opportunities.
For example, what do you think would happen if the government encouraged us all to put a chunk of our income into financial markets each time we get a paycheque?
Do you think this might have a significant, predictable and regular impact on stockmarkets each time we get paid?
If you do, you need to see this calendar which will tell you exactly when a wall of money will hit the market.
Editor, Fortune & Freedom