Allison's book is all about understanding risk and how to manage unwanted risk. This book uses a series of interesting stories to help the reader understand several "rules" related to risk. What follows is a series of quotes I found interesting while reading this book and my associated commentary.
The importance of having a goal
Taking a risk without a goal is just like getting in a car and driving around aimlessly expecting to wind up in a great place
knowing what you want might be the hardest part of risk management
Over the course of my career one of the more interesting things I've observed both in my personal and professional life is just how difficult it can be at times to clearly specify goals. We have all been part of performance review processes where we are asked to specify our goals for the upcoming performance period and became somewhat paralyzed as we assessed what we wanted out of the future. At a corporate level sometimes defining a strategic vision, clearly identifying objectives, including return objectives, becomes difficult in practice.
This is not to say that there aren't times when we can clearly articulate what we want, but simply to say that there are certainly times where defining what we want is challenging.
Further, how we frame what we want, our goals, can lead us astray. Using Schrager's example, how often have we framed what we want as simply "change", without defining further what we specifically want to the changed outcome to look like, what exactly will change. For example, we all generally know that a goal of "taking a vacation" is going to be much better defined by being specific as to what you want out of the vacation. Do you want to sit on the beach or go skiing? Both satisfy the goal of "taking a vacation", but they clearly are very different outcomes.
taking a risk on the unknown for its own sake is a bad risk strategy
The risk of misspecification of goals is a risk that we don't think about managing, likely because we sometimes want to skip the step in the risk management process where we set our goals and objectives.
Why we want what we want is a topic for another discussion and something I'll cover when I review Wanting: The Power of Mimetic Desire by Luke Burgis in a forthcoming post.
Is risk-free enough to meet your objectives?
Identify your goal and then price it in risk-free terms.
Taking more risk than necessary is inefficient
The price of that risk-free asset is the most critical piece of information in any investment problem, or any decision you might face.
As we sit here in 2023, interest rates have risen at the fastest pace in the last 40 years. Risk-free rates, the yields on U.S. Treasury securities, are as high as in the 5% range. If you have a monetary goal or return objective of 5% over the next year, you can very likely achieve that return without much risk (at least in nominal terms).
Risk-free depends on your goal.
In your personal life it can be much harder to define the "risk-free" option, and Schrager makes clear this fact by stating:
it can be hard to see the risk-free choice because there is no single universal risk-free asset; it depends on your goal.
Schrager provides an example that likely resonates with anyone who has shopped for house these last few years. "If your goal is getting that specific house, the risk-free option is putting in a large bid...as much as you are prepared to pay - to ensure you get it." If your goal is different and you want a house you think is a good bargain, then "you should pay less than what you think the house is worth and be comfortable with the risk of losing a bidding war."
All said, it's universal that we shouldn't want to chose a higher risk path when a lower risk path can achieve our objectives.
Probably not, you likely will need to take some risk in life
Crucially, risk can lead to good outcomes, "rewards", as well as the bad outcomes we most often associate with risk. We all learn the old saying "no risk, no reward". To reach our goals we often have to take some level of risk. In your personal life if you're training for a physical goal, like running a marathon or earning a black-belt in a martial art, you inevitably face some risk of injury. When managing a business you face some economic risk from every strategic decision, from personnel management, to product development.
smart risk taking involves going for more, and taking just enough risk that we need to, or are comfortable with to achieve our goal
What makes this so difficult is assessing the probabilities associated with each of the good and bad outcomes. I have often counseled the obvious, that you should avoid risk that lead you to blow up, the one's you can't recover from easily or ever.
So how do you Quantify and Communicate Risk
A good risk estimate requires data that can do two things: (1) reveal lessons from the past that will be relevant to the future, and (2) predict that certain past outcomes are more likely than others.
The hard part is knowing what constitutes a reasonable range
they often assume a normal distribution and use volatility as a standard measure of risk....normality is a controversial assumption.....if your distribution is skewed, volatility will underestimate risk.
that's the thing about predicting the future from based on the past. It works until it doesn't...Often we don't realize the world is changing until long after it has changed.
When we think about the risk we want to take or avoid, we often look to the past. This makes intuitive sense. As a child we learn to avoid touching a hot stove or that bees can sting as risk to be avoided. We also learn through parables, traditions, and formal schooling the stories both of risk to avoid as well as risk that was rewarded. We learn from the past.
The most common ways we get probability wrong are: 1. We overestimate certainty 2. We overestimate the risk of unlikely events. 3. We assume correlations that don't exist. 4. We put a big weight on very likely or unlikely events and put almost no weight on anything that happens in between.
Because we live in an age of data, it is easy for us to want to quantify all known past risk and stop there. Often it's better to take some time to consider risk qualitatively as well, brainstorming "what ifs" to see if the past data encompasses things you might want to consider before deciding whether to take or manage a risk. We often find ourselves in scenarios that are sometimes described as "regime changes", where past data provides little usual information in uncovering future probabilities. Thinking creatively can help you challenge the data before making a decision.
Manage risk you don't want to take or aren't being rewarded for taking
hedge: giving up some of your potential earnings in exchange for reducing risk
When we hedge, we give up some of our potential gains in exchange for reducing the chance of loss.
With hedging you must take less risk; you give up the extra upside of your potential reward in exchange for lessening the risk that something goes horribly wrong.
As someone who helped clients manage unwanted interest rate and currency risk, the act of hedging is near and dear to my heart, but a complex subject. For some business managers, the decision to hedge can be simple because your investors aren't rewarding you for taking on a certain risk. For example, if you manage certain assets, your investors may not reward you for generating returns due to fluctuations in foreign currency in your investments, but they may certainly punish you if you take that risk and lose money because of that decision. In this case managing foreign currency risk may be an easy decision.
In other situations you may not have a choice around what risk you manage. We all are familiar with being required to insure our homes and automobiles. In certain financial transactions you may be required to manage interest rate or foreign currency risk as a condition to the transaction.
de-risking increases the odds of your getting what you want, but you must give up the possibility of getting more....Hedging does not differentiate between systematic and idiosyncratic risk, but it can reduce both types.
The thing about "hedging" is that it's a good news is bad news story. For example if you own a foreign-denominated asset, if the foreign currency appreciates against your currency that's good news for your asset. However, foreign currencies can be volatile and given the chance the foreign currency might depreciate against your currency, you may choose it's a risk that you need to manage to ensure you meet your return objectives. In that case you may decide to hedge, or lock-in a future price at which you can sell/exchange your foreign currency from your asset for your local currency. However by doing so you now can no longer benefit from foreign currency appreciation. So when the foreign currency appreciates, the "good news" on the underlying asset is now offset by "bad news" or losses on your hedge position.
Sometimes we want the possibility of more
With insurance you get rid of downside risk, but the upside, or upper tail, is still all yours (minus the cost of insurance).
Purchasing insurance or using options as a risk management tool is a way to remove downside risk while still retaining the ability to benefit from scenarios that are favorable to you. For example when you insure your house you pay a premium such that the risk of loss due to fire is removed, but if your house doesn't burn down and continues to appreciate in value you get to keep the upside. When a company manages interest rate risk or foreign currency risk using option products they can set a level of protection that corresponds with their risk management objectives and retain the upside of favorable moves in interest rates or currencies.
Even if we don't buy insurance, the price helps us gauge risk and understand which situations are riskier than others.
Of course insurance isn't free and sometimes insurance can be very expensive. As to why it can be expensive, it's useful to understand the underpinnings of how options are priced. Schrager helps provide a basic understanding of option pricing models:
Vega: the larger your volatility is, the more risk you have to give up to protect yourself from bad outcomes.
Delta: sometimes one scenario is more likely to need insurance than the other. And the more likely you are to need insurance, the more expensive it is.
Theta: how long the risk will last. "fallacy of time diversification"..a longer time in the market means more risk
Rho: how much you earn without taking any risk at all..Risk-free also represents how much it costs to finance a risky bet
It can be unfortunate, but not terribly uncommon, that people or businesses find themselves in a situation where they are effectively chasing the management of risk. Often this occurs because they didn't have any established risk management process at the onset of their decision making and the unwanted risk taken only becomes obvious later, which of course is generally at a time when that risk is expensive to manage.
But can we ever get more for less risk?
In finance risk is the input and reward is the output...Markowitz argued that diversification was how investors could create efficient portfolios.
Financial economist separate risk into two broad categories: the first is idiosyncratic risk, or the risk unique to a particular asset...The second kind of risk is systematic risk, or risk that affects the larger system instead of an individual asset...Systematic risks are harder to manage than idiosyncratic risks, and the downsides are potentially more dangerous.
Study after study shows that actively managed mutual funds, the ones that contain professionally picked stocks, don't offer higher returns than index funds after adjusting for risk and fees.
In finance diversification is often referred to the closest thing to a free lunch, it's the concept that you if you make a bunch of uncorrelated bets some winners will offset some losers and you'll be left with only the systematic risk that is common to all of the bets. It reduces the chance you just made a bad bet and or got unlucky at the expense of reaping all of the rewards of making an extremely correct single bet. Whether all correlations go to "1" in some extreme events is a topic for another day.
Schrager offers up one of the best diversification strategies in life:
Having more friends increases the odds someone will be available when you need them.
Common Mistakes
As mentioned above, sometimes the hardest part of risk management is identifying your goals and objectives. The failure to know what you're after often leads us astray and allows us to become more susceptible to behavioral biases.
Risk offers the possibility of more, and risk management tools aim to empower us to go for more while taking less risk. Using them correctly involves staying focused on our goals and taking just enough risk to achieve them.
Prospect Theory says when we weigh different options, the value we place on them depends on how much money we have when we start and if there is the possibility of loss....Prospect Theory argues that humans are risk seeking, or willing to take a chance on even bigger losses to forgo certainty when offered a menu of loss scenarios.
The other way we often see excessive risk taking lead to challenges is when leverage is used. In finance, leverage is the use of borrowed money to make a risky investment. Often leverage is needed to magnify returns to equity to reach objectives. Inherently there is no problem with leverage per se, but applying leverage to a volatile asset or a volatile set of cash flows can cause ruin.
leverage...it is a negative hedge...how people magnify risk
Over the course of my career, I sometimes encountered a situation where the probability someone was assigning to negative scenarios (risk) was quite high and they were looking to manage that downside risk. In those scenarios, if you truly believed the probability of a recession was much higher than anyone else in the market and were convinced the probability was 100%, it would seem the best way to manage that risk would be to sell all of your risky assets.
The simplest way to hedge is to simply take less risk.
Sometimes taking less risk is the correct strategy but again our behavioral biases can lead us to flawed decision making, especially when we are evaluating risk while sitting on losses.
We have an aversion to loss and sometimes that can lead us to take bigger risks than we should or even realize
Riskless is unobtainable
Edwin Goldwasser posited that “A riskless society is 'unattainable and infinitely expensive" and that is true. As discussed above, to meet goals risk some level of risk must be taken.
We can reduce uncertainty but never eliminate it.
Uncertainty makes us uncomfortable, and it is costly to deal with.
we can never anticipate everything that will go wrong or right, and if we think we can, we set ourselves up for failure.
Risk models can't account for everything that can possibly happen, and they are not meant to.
Realizing that some risk is necessary and unavoidable, it remains prudent to maintain flexibility and some margin of safety where possible. As Schrager provides:
think creatively and be open to things unfolding in ways different from what they expect....flexibility comes with a cost....retain the option to change course when our plans go awry and have the humility to follow through.
Know your goals, mitigate unwanted risk, prepare and position the best you can for when the unknown or unexpected occurs, because life is uncertain, but remember without risk there is no return.
