10 must-read insights on risk

By Larissa Fernand |  30-11-20 | 
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About the Author
Larissa Fernand is Senior Editor at Morningstar.in. Follow her on Twitter @larissafernand

Peter Bernstein, finance historian and captivating author, was an expert on the subject of risk.

The derivation of the word “risk” reaches back to the early Italian risicare, which translates as “to dare.” Risk looked at from this viewpoint is a choice rather than a fate. And it can broadly be viewed as the probability of something going wrong, and the negative consequences if it does.

Once you grasp the nuances of risk, your investment quotient will increase substantially. These brilliant insights have been taken from Against the Gods and the interview with Jason Zweig and interview with PBS.

The lens through which you view wealth is crucial.

Like your children, wealth is the primary link between your present and the future. When you invest today, it's your future that you are really managing.

Think about your wealth the same way you think about your children. You want your children to have freedom, but you also want them to be good people who can take care of themselves. You don't want to blow it, because you don't get a second chance.

Maximising return is not a strategy, survival is.

In general, survival is the only road to riches. The trick is not to be the hottest stock-picker, the winning forecaster, or the developer of the neatest model; such victories are transient. The trick is to survive!

Maximizing return is a strategy that makes sense only in very specific circumstances. Try to maximize return only if losses would not threaten your survival and if you have a compelling future need for the extra gains you might earn.

Diversification is as much about survival, as it is about aggression.

In 1952, Harry Markowitz demonstrated mathematically why putting all your eggs in one basket is unacceptably risky and diversification is the nearest an investor can come to a free lunch.

Is diversification a guarantee against loss? No, only against losing everything at once.

Diversification is as much about survival, as it is about aggression. The next windfall might come from a surprising place, ensure that you are exposed to it.

Diversification is an explicit recognition of ignorance; since we are ignorant of the future, cover all bases.

If you're comfortable with everything you own, you're not diversified. For instance, outside equity and debt, consider small allocations to gold, foreign currency, and TIPS [Treasury Inflation-Protected Securities].

Investors do better where risk management is a conscious part of the process.

Understanding the risk, and the art and science of the subsequent choices, lie at the core of your investing strategy. The capacity to manage risk and the appetite to take risk are the prime catalysts of the portfolio.

Essence of risk management: maximizing areas where we have some control over outcomes while minimizing areas where we have no control.

In 1703, mathematician Gottfried von Leibniz said: “Nature has established patterns originating in the return of events, but only for the most part.” Outside “the most part” lies the unpredictable.

We don't know what's going to happen with anything, ever. And so it's inevitable that a certain percentage of our decisions will be wrong. There's just no way we can always make the right decision. That doesn't mean you're an idiot. But it does mean you must focus on how serious the consequences could be if you turn out to be wrong: If this doesn't do what I expect it to do, what’s going to be the impact on me? How wrong could it go? How much will it matter?

You don’t have to be convinced beyond doubt that you are right. But you have to think about the consequences of what you're doing and establish that you can survive them if you're wrong.

Consequences are more important than probabilities.

One winter night during one of the many German air raids on Moscow during WWII, a distinguished Soviet professor of statistics showed up in his local air-raid shelter. He had never appeared there before. His reason: ‘There are 7 million people in Moscow. Why should I expect them to hit me?’ His friends were astonished to see him and asked what had happened to change his mind. His answer: ‘There are 7 million people in Moscow and one elephant. Last night, they got the elephant.’

The professor’s experience illuminates the dual character that runs throughout everything to do with probability: past frequencies can collide with degrees of belief when risky choices must be made. When complete knowledge of the future is an impossibility, how representative is the information we have in hand?

Only in rare cases does life replicate games of chance, for which we can determine the probability of an outcome before an event actually occurs – a priori. In most instances, we have to estimate the probabilities from what happened after the fact – a posteriori. There were 7 million people and 1 elephant. After the elephant was killed by a bomb, the professor decided that the time had come to go into the air raid shelter. But an estimate of probabilities after the fact also is impossible unless we can assume that the past is a reliable guide to the future.

The times I have been most wrong are the times I thought I was most right.

It is a cliche to say we cannot ever read the future, but the effort to locate the critical point between information we can trust and information we can only guess at is an indispensable ingredient of successful investing.

There are occasions when we are convinced the short-term news is only noise and the real information is in longer-term trends. But the difference is a mirage: We must still distinguish between trusting and guessing.

Risk and time are opposite sides of the same coin.

If there were no tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon: the future is the playing field. Time matters most when decisions are irreversible. And yet many irreversible decisions must be made on the basis of incomplete information. Irreversibility dominates decisions ranging all the way from taking the subway instead of a taxi, to building an automobile factory in Brazil, to changing jobs, to declaring war.

Hamlet complained that too much hesitation in the face of uncertain outcomes is bad. Yet once we act, we forfeit the option of waiting until new information comes along. As a result, not acting has value. The more uncertain the outcome, the greater may be the value of procrastination. The more irreversible the decision, the more expensive the consequence of being wrong.

Hamlet had it wrong: he who hesitates is halfway home.

Regression to the mean is most slavishly followed on the stock market.

Investors are emotionally incapable of buying low and selling high. Impelled by greed and fear, they run with the crowd instead of thinking for themselves. Since we never know what exactly is going to happen tomorrow, it is easier to assume that the future will resemble the present than to admit it will bring some unknown change.

Extrapolation is the biggest mistake investors make. Leaving fund managers in a down year to go with whoever's hot. A stock that has been going up for a while somehow seems a better buy than a stock that has been heading for the cellar. We assume that a rising price signifies that the company is flourishing and a falling price signifies trouble. Stocks with rosy forecasts climb to unreal heights while stocks with dismal forecasts drop to unreal lows. Then regression to the mean takes over.

Legendary investors who made fortunes bet on regression to the mean, by buying low and selling high.

Risk-taking is an inevitable ingredient in investing, and in life, but never take a risk you do not have to take.

The riskiest moment is when you're right. That's when you're in the most trouble, because you tend to overstay the good decisions.

In the late 1950s, a man approached us with a portfolio of $200,000 on margin in just three stocks. He had lost his job as a reporter. His wife was a schoolteacher. They had $15,000 in the bank. He decided to shoot the moon. If he lost it all, they would be broke one year sooner. But if it paid off big, it would change their entire life. So, for him, the consequences of being right dominated the probabilities.

He came to us because he could not bring himself to unwind the tremendous gains in his portfolio. His wife, who had been calm and supportive on the way up, was now terrified of losing it as they had made it big. So we diversified the portfolio for them.

Can you manage yourself in a bubble, and can you manage yourself on the other side? It's very easy to say yes when you haven't been there. But it's very hot in that oven. And can you save your ego, as well as your wealth?

We are all going to be wrong more often than we expect.

Understanding that we do not know the future is such a simple statement, but it's so important.  As a result, being wrong is inevitable and normal, not some terrible tragedy, not some awful failing in reasoning, not even bad luck in most instances. Being wrong comes with the franchise of an activity whose outcome depends on an unknown future.

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