We’re all risk managers now

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Contrary to first impressions, big wave surfing is all about risk management.

In the late 1980’s legendary Hawaiian big wave surfer Brian Keaulanu looked at the new models of jet ski that were being produced like the Yamaha Waverunner that allowed the rider to sit down, and had a flash of inspiration. He realised that these machines could be used to swiftly rescue big wave surfers caught in dangerous situations. Not long after, he became a fixture at the most treacherous big-wave locations, and the surfers even refused to hold competitions without him – the surfers had quickly realised this was a very low cost and effective form of insurance, which they would be very foolish to ignore, whatever their overall tolerance for risk in pursuit of big wave thrills.

This story has an interesting twist though, for it didn’t take the surfers long to figure out tht jetskis could do something else for them as well. They could tow the surfers into far, far bigger waves than what they could naturally paddle into before. So the jet ski became at once a device that could both reduce, and vastly multiply the surfers’ risks. Not unlike a financial derivative in many ways (read more in Allison Schrager’s excellent book – An Economist Walks into a Brothel).

The “exit strategy” from the covid19 lockdowns has turned all talk now to balancing risks: open up and risk a second peak? Or stay closed and risk economic and financial hardship? And for individuals – wear a mask? Take the tube? Stay home? Meet friends & family, travel?

It may sound like impossible choices but of course we balance risks effectively in all sorts of pursuits already, you might say it’s inherent to modern life.

One key here is to get away from black and white thinking. It is far too simplistic to help us in complex domains. Of course the debate isn’t all about full re-opening or full closure, just as investing isn’t all about 100% cash vs 100% investment in the latest hot tech stock.

Investing over the long-term is all about balancing risk: there are always hundreds of risks that could damage your portfolio or throw you off course, but hedging them all ends up with you stashing cash under your mattress. And we know there’s good evidence that investing “works”, over long periods in spite of – or perhaps because of – the risks (“now show Japan”).

When exploring the terrain of the area between the extremes, risk management is a key discipline and language to guide us. So potentially we have a lot to learn from risk managers and risk economists right now.

Of course, we’re all inherently wired to dislike uncertainty and to try and remove it. But it’s not always possible, or at least avoiding uncertainty often comes with a heavy cost in itself, which we need to think hard about before paying. It’s risk management that lets us navigate uncertainty sensibly.

I was fortunate enough to sit down with renowned risk author and economist Allison Schrager not too long ago and she talked through her simple but powerful model for how to manage risk, as well as colour it with some entertatining stories – including that story of the big wave surfers who she spent time studying (just “actuaries with a better tan”) apparently.

Investment Uncut · Ep. 6 – Understanding Risk with Allison Schrager

7 pillars of risk management

Key advice from a risk economist:

  • Get clarity on the objective against which you are measuring risk. It is worth remembering in day to day life we run all sort of risks leaving the house or getting in a car each day, so zero risk isn’t a reasonable objective. In investing the mistake is often to confuse a long-term income generating objective for a short-term wealth preservation objective
  • Use risk models for what they are worth, focus on communicating results well using natural frequencies rather than percentages. Particularly relevant now of course, helping people understand their own risks (and those of the people around them), and how these vary by age and other factors is tough, but aruably never been more important.
  • Understand how you can diversify, spread your risks/avoid concentration of risk, and do this as much as you can in your situation
  • Figure out what hedges you have at your disposal, and how much these cost you to implement. A hedge is a position that gives an offset to an existing position, so you get an offset on both upside and downside. Staying home as a solution to covid19 is close to a hedge.
  • Figure out where you can deploy insurance (pay away a fixed cost to take away your downside, but you keep the upside). Insurance usually has to be put in place in the good times to work in the bad times. Fire and flood insurance get bought after fires and floods, but the next crisis won’t look the same as the previous.
  • Deploy a suitable mix of hedging and insurance strategies to help manage your risks.
  • Put resiliency into your plan so that you can keep going even if something totally out of the ordinary happens. One big challenge in building resiliency is that it has a cost, it often runs counter to optimisation and looks like in-efficiency in the good times. Profit-maximising firms will struggle to build resiliency. For example resiliency right now looks like excess capacity in healthcare systems.

If you follow these steps you’ll be in a better place by judging any plan against the right objectives. Insurance, hedging and resiliency all come with associated costs, so don’t jump to paying away too much for certainty – you’ll want to explore the combinations of these approaches that can get you to an expected outcome you can live with, not forgetting to make sure that you see how far divesification can get you before you start paying for the additional certainty of insurance, hedging or resiliency.

You may also be interested in Amplifying Certainties and why we get on planes (or put out trust in complex things we don’t understand).

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