Dealing With The Only Risk That Matters

The central problem in finance, around which everything revolves, is 'uncertainty'. All payoffs are determined by the level of uncertainty involved. At the heart of any theory or model is an attempt to predict the future. Risk stems from uncertainty, and in my opinion, the central risk that exists is the risk of ruin. The conundrum lies in the fact that what ruins you is almost always unpredictable, so what should you do?

Risk is Not About Volatility...

Risk is the single most misused word in finance. Ask anyone if an investment with a 15% expected return is riskier than one with a 10% expected return and the answer will be a resounding yes. This 'high-risk-high-return' heuristic (rule of thumb) is universally accepted, but it doesn't give you the full picture. What you see labeled as risk is in fact variability; the importance of that distinction will soon become clear.

What people call 'high-risk' is actually just variability of returns, in both directions, and the underlying reason for this variability is the level of uncertainty involved. Uncertainty can never be eliminated or quantified, but it can be compared, and as such payoffs are based on relative uncertainty. The future of the United States as a country is less uncertain than that of a single company; consequently, the payoff for investing in the United States should be relatively less uncertain. The greater uncertainty involved in the case of a single company implies a wide range of future states, both good and bad, and thus the payoff determined by one of the many possible outcomes has greater variability. In lieu of accepting greater variability, investors typically demand a relatively higher payoff.

For instance, the interest rate on an AT&T bond will be higher than on a US Treasury bond (backed by the United States). However, it's important to remember that the uncertainty never goes away, and depending on how the future plays out the AT&T bond's actual return could end up being relatively lower. Therefore, it's not quite the case that AT&T is necessarily riskier than the United States, it's more so that its future is more uncertain so your return is subject to higher variability and the question is whether or not the variability suits your purpose. However, too much of anything is not good. Add enough eggs to the AT&T basket and you'll expose yourself to real risk. The only risk that truly matters and one that's the most forgotten - risk of ruin.

...It's About Staying in The Game

Amidst all the noise around issues that have more to do with variability than with risk, many tend to forget that survival precedes success. Theories and models that claim to measure risk are merely approximations of variability based on historical data, and give people an illusion of control while their true exposure remains under the radar. This is what gives rise to the Black Swan problem which I discussed in an earlier essay (Extreme Outliers - The Black Swan Problem).

Real risk pertains to the breadth of consequences you face in any scenario and your capacity to endure them without facing ruin. Risk cannot be measured as it stems from uncertainty that cannot be removed. It's mathematically impossible to be definitive about something that is both unmeasurable and unpredictable.

So how do you deal with ever-present uncertainty and the ensuing Black Swan problem? This is where Nassim Nicholas Taleb's idea of 'Antifragility' comes in.

Neither Fragile, Nor Robust

Things can be classified as either fragile, robust, or antifragile. Anything that has more downside than upside from uncertainty is fragile, vice-versa is antifragile, and the linear (downside = upside) is robust. Put differently, everything that is nonlinear in its response to uncertainty is either fragile or antifragile. The path to antifragility begins with lowering exposure to negative Black Swans and mitigating risk of ruin. Ray Dalio's (founder of Bridgewater, the world's largest hedge fund) investment philosophy is anchored by his belief in making sure the "probability of the unacceptable is nil".

Our fragility lies in our vulnerability to the variability of things that affect us. Instead of trying to test if something is antifragile, focus on figuring out if it's fragile to the variability/volatility it faces. Our knowledge grows more from subtraction than from addition. A single observation can disprove something, while millions may not prove it. All you need to determine if something isn't antifragile is one observation that disproves it, and if you eliminate enough of such observations and thereby structures that are fragile (i.e. grow knowledge by subtraction) you'll end up closer to antifragility.

You might be thinking, 'If antifragility is merely a method to mitigate risk of ruin, aren't there simpler approaches, like investing in US Treasury bonds?' What sets antifragility apart, however, is its ability to not only reduce risk of ruin but also to preserve upside potential. The payoffs associated with antifragility are asymmetric and you have more upside than downside. While this method (a barbell / bimodal strategy) is applicable to various disciplines, for this essay I'll focus on an example from finance.

Let's say you put 80% of your funds in hyper-conservative assets that track inflation (to maintain purchasing power) and the remaining 20% in hyper-aggressive speculative bets. This barbell / bimodal strategy will ensure your losses are capped at a level acceptable to you, and even a single successful speculative investment will bring a massive payoff that'll dwarf all other failures. In contrast, let's consider a traditional 60% / 40% (stocks / bonds) portfolio. Contemporary theories and models dictate that theoretically both the traditional and barbell portfolios have a nearly identical 'risk' profile given that the highly speculative bets in the barbell case are offset by the highly conservative allocations. However, if you apply the approach discussed in this essay and focus on risk of ruin, everything changes. In a severe market downturn there is undeniably a non-zero probability of catastrophic losses for a traditional portfolio, but a barbell portfolio is sure to survive. Therefore, your exposure to negative Black Swans is minimized whilst your upside from positive Black Swans remains. This is the essence of antifragility and the only viable 'solution' to the Black Swan problem I've encountered.

Why Should You Care?

It's possible that you may never encounter a Black Swan in your lifetime, and many who are oblivious to its existence have done just fine. Many, not all. Just because a risk didn't become a reality doesn't mean it didn't exist. You'll never know when or where the next extreme event will come from, just make sure you live to fight another day.

This essay was inspired by Nassim Nicholas Taleb's 'Incerto' book series.

Disclaimer: All content is for informational purposes only and should not be construed as legal, tax, investment, or financial advice. All opinions expressed are strictly my own and do not represent those of any company or third party.