Risk Assessment: Try Not to Get Eaten By a Rabid Possum

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“Assessing risk a low priority,” report Saskia Scholtes and Richard Beales in today’s FT. “Fewer than half of global financial institutions account sufficiently for complex financial and commodity exposures in assessing the risk of their holdings, according to a survey by Deloitte…The results suggest that much of the industry may ‘lag behind the explosive growth of credit derivatives and their attendant risks,’ the firm said.”

This shouldn’t surprise anyone. The economy, like nature or an ecosystem or a city, is a complex adaptive system. You can’t prepare for every possibility. You could get hit by a bus, electrocuted by a falling power wire, attacked by rabid possums, or eaten by a shark in the Yarra. The risks to your safety in the modern world are so numerous that if you took time to calculate and hedge against them all, you’d be locked in a room for the rest of your life (eventually you’d identify that as a risk too, but by then it might be too late to do anything about it.)

That’s why simple rules, in both finance and life, are the best guides of prudent behaviour. They allow for action instead of paralysis. And usually, the action is low-risk and effective, if you stick with the simple rules. Just think “buy low, sell high,” and you’ll see what we mean.

In this way markets are also like the state of nature: the goal is not to be killed. You survive first, and thrive based on your survival skills and strategy. The more risks you expose yourself too, the greater the likelihood you “blow up” or get eaten.

This is why Warren Buffett and Peter Lynch talk so much about investing in things you understand. They don’t say it because they are old-fashioned, un-imaginative simpletons. They understand there is such a thing as a division of mental labour in the modern world. You only have so much capacity to understand what makes a good investment and what does not. That’s why simple rules—buy stocks with low p/e ratios, low price-to-sales ratios, and high dividends—are so effective. They are guides for effective action over time.

It’s the introduction of so many novel ways to “hedge” risk that actually have made us less safe, financially speaking. We’ve taken on more risk for a limited upside. What a stupid, if exciting, trade. As usual, simple rules work best, and still allow for a huge variety of outcomes in the world, whether in chess, romance, or finance.

Speaking of complicated and perhaps stupid trades, we were asked a tough question by a colleague yesterday on the phone. “Do you think you’re doing the right thing?” he asked. He was referring to our decision to remain in Australia while our father back in Colorado battles prostate cancer.

“Who knows? Every day all around you people are going through their own private traumas and crises. And they manage to make it through. Our situation isn’t any different. You hope you do the right thing. Does the world really need more analysis on the direction on interest rates?

Probably not. But you can’t always drop everything when death and dying walk into your life, unless it really is your life, in which case you don’t have much choice.”

“True, but do you ever think you should be back there instead of in Australia?”

“Of course. But you have to ask yourself a couple of questions. What can you really do? What are you willing to do? When someone is terminally ill, you can only provide your time and attention. Then you have to decide if you’re going to even do that.”

“What does your dad say?”

“Not much. He’s settling up his own accounts with life, proceeding with his own reckoning you could say. He has thirteen children and he’s sixty-eight years old. That’s a lot of reckoning. He always used to reply cryptically when we asked him for any sort of advice that you have to “Live for the single purpose of the moment…and that the map is not the territory.”

“Huh?”

“Exactly. How can you know what the single purpose of any moment is, unless you’re brushing your teeth or tying your shoes? Does any moment have just one single purpose? Isn’t that single-minded?  How do you recognize what you’re supposed to do or say? And don’t you have to make plans in life too, like how to pay your mortgage and where to send your kids to college? Orthodontic bills don’t pay themselves. At least with money you can’t live so impulsively, so romantically. It just doesn’t work.”

“Yeah, but your dad isn’t a mortgage. He’s your dad.”

“That’s true. But there still doesn’t appear to be any simple rule for this situation. You just try to do the right thing, whatever that means.”

“Why don’t you ask you dad?”

“He doesn’t talk much anymore. He can’t. He sleeps a lot. And he likes being read to. Maybe we’ll read him some of our latest musings.”

“Don’t do that. I’m sure he’s depressed enough already.”

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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