What Is Risk? — Understanding Risk in the Financial Industry

What Is Risk? — Understanding Risk in the Financial Industry

Sounds like a stupid question, I know.

But consider this. Your definition of the word ‘risk’ and the definition used by the financial industry supposedly serving you are completely different. And the gap is the source of rather a lot of anguish, if you ask me.

Today we explore the rift. The evolution of risk.

Like much of what we cover here at The Daily Reckoning Australia, it all makes more sense with a bit of history…

Risk, in its simplest form — the dictionary definition — is the chance of something going wrong. That’s what most of us mean when we mention ‘risk’.

But did you know that, in the financial industry, it’s also the chance of something going right? They see risk as a sort of probability measure. Back to that below.

Going way back, we may have simply thought about risk in its simplest form. The chance of a bad event. But, over time, our understanding has evolved. For good and for ill. Let’s dig into both sides of the coin.

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A world without risk is stagnant

In his book, Against The Gods: The Remarkable Story of Risk, Peter Bernstein sees risk-taking as the driving force behind the evolution of our entire species. Again, sounds silly given the definition of risk. But if you think about it, that is not an outlandish idea, is it?

It was quite a risk to leave your cave and hunt for some bearskin to keep you warm at night. But we did it anyway. And, once we figured that out, if we (as a species) wanted something better for ourselves or our nations…it came at a potential cost. It came with risks:

The revolutionary idea that defines the boundary between modern times and the past is a mastery of risk… until human beings found a way to cross that boundary, the future was a mirror of the past or the murky domain of oracles and soothsayers who held a monopoly over knowledge of anticipated events.

The idea that risk is a matter of chance which may or may not be worth taking, as opposed to a decision by the gods to dish out misfortune, enabled us to think more clearly about whether to take risks. And choose which ones.

Although the future is unknown, there can be enormous and lasting rewards for taking a chance on favourable outcomes. That’s the first key realisation. That risk and reward are somehow related.

And this is a powerful and potentially transformative idea in our financial lives, too. It’s one of the first and only useful things you’d learn in a university finance degree.

If we can tolerate the risks, and accept that not all investments will be winners, the rewards can have a big impact.

Making strategic, well-researched investments still has risk. If we ever forget to mention that, well, it’s a mistake.

But I hope you can see how risk shifted from ‘something bad’ to a trade off between risk and reward.

Then the academics got a hold of the concept…

Gamification of risk

Our modern understanding of risk comes from scientific insights about gambling and games. Betting odds, in effect.

Statisticians and philosophers derived rules and axioms about our world based on games of chance.

What is the probability of tossing heads three times in a row? If a game of cards is interrupted by the King of France summoning one of the players, how should the stakes be divided between players in a fair way given how the game has unfolded so far? And then there’s the infamous ‘Two Child Problem’. Don’t go down that rabbit hole…

Many of the axioms discovered in such ways still have a huge influence today. They’re used in financial markets.

One key insight is that risk is not just about probabilities. It’s also about outcomes.

Betting on the favourite in a horse race is likely unwise because the payoff will be smaller too. For the bookies to win, the odds always have to be slightly smaller than what would be worth making the bet at. Unless you have some inside information…which is why that’s what all the racecourse drama is really all about.

One of Nassim Taleb’s many books about risk is about the importance of the outcome. You don’t expect your home to be swept away in a flood. But you buy insurance nevertheless…because the outcome is so large and impactful.

In the book, Taleb recalls a regular meeting where each trader at the investment firm was asked whether they thought stocks would go up or down, and why. When Taleb said ‘up’, one of his colleagues burst out ‘but you told me you were short’, meaning Taleb had bet on markets falling.

The two seem contradictory, but they’re not. Taleb replied by explaining that the market was more likely to go up, but if it did go down, it would go down a lot further than it would go up. Once you factor in the size of the move, not just the direction, it made more sense to be short.

At least that’s how I remember the story. Taleb is more likely to have called everyone in the room an idiot and never attended such a meeting again…

What made Taleb so successful was his willingness to be wrong most of the time, but when he was right, his winnings were big enough to outweigh the losses. He founded a firm largely based on this principle. It’s the opposite of picking up pennies in front of a bulldozer. It’s driving the bulldozer and picking the pockets of the victims you run over. But not many financial professionals can wait as long as Taleb is willing to for his payday.

The fact that Wall Street traders didn’t intuitively get Taleb’s point about outcomes is important to you and me, as regular investors. It may give us an edge. Because you and I don’t have risk managers or supervisors judging our quarterly performance. We can wait for returns like Taleb does.

The pretence of probabilities

Another of Taleb’s books, or perhaps it’s the same one, is about outcomes which we simply weren’t able to understand with probabilities in advance. They’re known as Black Swans because we just can’t even conceive of them until they happen in front of our eyes.

The former Bank of England Governor Mervyn King, whose book Radical Uncertainty inspired some of today’s editorial, explained a similar idea like this:

We picked [the title for our book] because so much uncertainty, in the world of economics, people are desperate to quantify it. And our view of radical uncertainty is that it’s uncertainty that you cannot easily quantify.

I mean, the best example, I think is what we’re going through now, COVID-19, in which we knew, well before it happened, that there could be things called pandemics. And, indeed, we say in the book that it was likely that we should expect to be hit by an epidemic of an infectious disease resulting from a virus that doesn’t yet exist.

But, the whole point of that was not to pretend that we, in any sense, could predict when it would happen, but the opposite. To say that: the fact that you knew that pandemics could occur did not mean that you could say there was a probability of 20% or 50% or any other number that there would be a virus coming out of Wuhan in China in December 2019.

Most uncertainty is of that kind. It’s things where you know something, but not enough and certainly not enough to pretend that you can quantify the probability that the event will occur.

That’s where finance went wrong — my main point today. Not just by making the presumption that something bad wouldn’t happen. Not just mismeasuring its probability. But by turning risk into a game. In the sense that we can understand games, so let’s pretend risk and financial markets behave like one. Then we can pretend we know what’s coming in the future, because we can quantify it mathematically. A bit like a coin tossing game.

This presumption is what caused much of 2008’s crisis and many others. The presumption that financial markets are a game which conformed to the statistical axioms derived many years ago from games. Bell curves without fat tails, meaning rare events are too rare to worry about, for example.

But then such a rare event struck. US house prices fell. And global financial markets went haywire because this possibility wasn’t included in their models.

Why not? Answering that question helps illuminate the point I’m trying to make.

Nobody predicted this…in their models…

Do you remember hearing about how ‘nobody predicted the financial crisis’? Well, consider this interview segment from 2005, when Federal Reserve Chairman Ben Bernanke was asked about US house prices on a financial news show:

Interviewer: Sir, we have so many economists coming on our air and saying, “Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.” Some say it could even cause a recession at some point. What is the worst-case scenario, if in fact we were to see prices come down substantially across the country?

Bernanke: ‘Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis.

Turns out, not only were we warned. We were warned by ‘many economists’ who went ‘on air’ on a financial TV show. But the Federal Reserve Chair didn’t buy their premise because it hadn’t happened before. And, here’s the key bit, under modern economics’ theories, that’s a measure of the risk of it happening. And by that game-style measurement of risk, it can’t happen. Because it hadn’t.

Until it does…

When 2008 did happen, people inside the industry were mystified — another key fact you should bear in mind as an investor. Even after the event, there was confusion.

Risk analysts believed their models of risk were correct, but that an incredibly rare event had happened, instead of believing their models were wrong. They forgot the original nature of risk, which you and I think in terms of each day — the probability of something bad happening.

Bankers and their risk managers made all these mistakes despite the insights of people like Mervyn King and Nassim Taleb. Then again, their books were published with the benefit of hindsight. But at least both were on the front lines at the time of crisis…

One of the Bank of England’s original purposes was of course to help the British banking system through the sorts of market panics, which they hadn’t really foreseen and so weren’t protected from. It’s a little older than the US Federal Reserve. Perhaps that’s why King’s perception was a little different to Bernanke’s…

Science isn’t perfect, but it’s better than nothing, right?

You might be thinking what Mervyn King’s interviewer asked him in a podcast…

Russ Roberts: On the surface, you could argue — and some do — that, “Well, this is just part of science. It is imprecise, but we’re getting better.” Mervyn, what’s the danger of making that kind of precision on the grounds of it’s just doing the best we can?

Mervyn King: It’s not doing the best we can. It’s pretending that we know more than, in fact, we do.

And, there is a real danger in that. If you pretend to know a great deal more than, in fact, you do know, what you’re going to be doing is making judgments and decisions based on the false assumption that this is what would happen if you take one particular action rather than another.

And I think that deflects from what we in the book describe as the most important thing to do when confronted with a decision under uncertainty, which is to ask the very simple question: What is going on here? Because that is a way of actually getting to the bottom of what is happening.

Pretending financial markets are like games is dangerous.

Asking ‘what is going on here?’ — the theme of King’s book, is part of what we try to do at The Daily Reckoning Australia. Why we write narratives — what King is referring to by asking ‘What’s going on here?’

If you ask yourself that question when you play Monopoly with my little sister, you will find it surprisingly easy to predict what happens next. If you consult the rules of the game and calculate probabilities of various events happening, you’re in for a surprise…

My friend Glen can tell you exactly which cards I have in my hand during a game of poker. While I focus on the cards, he looks at my face and asks ‘what’s going on here?

The good news is that, like me playing Poker with Glen, the financial industry never learns their lesson. They continue to use models, which quantify risk based on what happened in the past instead of wondering what’s really going on in the economy and financial markets.

The ironically named Long-Term Capital Management blew up when financial markets failed to conform to academic models — the warning Wall Street should’ve heeded about 2008. The tech bubble of 2000 is back today, if you ask me. And risky European debt is still highly rated by credit ratings agencies, based on my analysis at least.

All this gives us an edge, if we keep asking ‘what is going on here?’

So that’s what we’ll do, for you…

Until next time,

Nick Hubble Signature

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend

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