PPP 2: Starting With Risk

There are several ways to view risk and its implications for investors. 

From a practical, financial planning perspective, what investors care about is their financial future. That’s why they invest in the first place. Robert Jeffrey summarised in 1984 (2) what risk meant in this context:

“The real risk in holding a portfolio is that it might not provide its owner, either during the interim or at some terminal date or both, with the cash he requires to make essential outlays.”

The problem with this definition is that it doesn’t really give us a usable way to analyse risk. How are we supposed to determine if a portfolio may or may not provide us with the cash to “make essential outlays”?

You can also differentiate the types of risk that investing is associated with: fluctuation risk and bankruptcy risk. Fluctuation risk encapsulates the risks resulting from the fact that assets, oddly enough, fluctuate in value. These risks are particularly important if you have uncle points or when you are liquidating your portfolio. Bankruptcy risk refers to the risk that the asset becomes worthless.

However, as you are investing in a portfolio of different assets (I hope!), your portfolio as a whole is not actually subject to bankruptcy risk in a traditional sense (3). Bankruptcy risk materialises on a portfolio level as severe fluctuation risk: certain assets in your portfolio losing all of their value will cause your portfolio to fluctuate (downwardly) in value, but it won’t go to 0. Hence, portfolios (most of them) are not really subject to bankruptcy risk.

Frank Knigt. Source: University of Chicago Centennial Exhibition Catalogues.

A more philosophical, and probably more accurate, approach would be to distinguish between risk and uncertainty. This is the distinction both Knight and Keynes made in the early 20th century (4).

Risk refers to contexts in which the generating function is known. Typically these environments involve repeated trials, are bounded and have iid outcomes. We should only apply probability and, therefore, statistics in these “special and crucial cases” (according to Knight). Uncertain domains encapsulate everything else. They are typically unbounded, complex, non-stationary, and difficult to work with. The generating function is unknown and may change over time.

It is unclear to what extent techniques developed in domains of risk, that is to say, pretty much all of probability theory and much of statistics, are applicable to domains of uncertainty (5). Uncertain environments may call for some other technique to manage risk outside of probability and statistics.

Although risk might be difficult to assess it is nevertheless vital to the composition of our portfolio and, in fact, should be the starting point of said composition. This is primarily due to the fact that we are playing a high stakes game. This isn’t Coppit. This isn’t virtual poker with the lads on a Saturday night (£10 buy-in with £5 re-buy). This isn’t your weekly accumulator that never works.

We are dealing here with money you have worked hard for. Have saved hard for. You can’t afford to fuck about. Hence, you must consider the risks involved with investments, and the risks of your portfolio as a whole, as a starting point.

Investing is a little more serious than Coppit. Source: For-sale.co.uk.

See what risks you can afford to take before worrying about potential gain. Granted, this is easier said than done. We are drawn to big returns like flies to shit. You must fight this urge. Before using half of the money in your savings account to buy the newest cryptocurrency that’s “going to be the next big thing”, consider “what if?”. Think about the fluctuation risk and bankruptcy risk associated with the asset. What if this loses half of its value? What if it loses all of its value? What will I do? Is that a risk I can afford to take? This is not a comprehensive approach to risk management by any means, but it’s a start.

Managing your portfolio is about managing the risks associated with your portfolio. First, ensure you aren’t taking risks you cannot afford to take. Returns come second.

Notes

(1) This is an elaboration of the one of the Principles of Perpetual Prudence.

(2) See his paper A New Paradigm For Portfolio Risk for more details.

(3) Well, probably not. It depends on what assets exactly you hold, of course.

(4) See Keynes’s A Treatise On Probability and Knight’s Risk, Uncertainty, And Profit.

(5) This is something Kenneth Arrow emphasised in his paper Alternative approaches to the theory of choice in risk-taking situations in 1951.


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