Dear Boys,
For a Brit, talking about the weather is like eating – you’ve got to do it every day just to survive..., but for our purpose, it’s also a great way to introduce the concept of risk. Risk is a big topic that will take more than a few Letters to delve into completely, but we’ll start with some principal observations to set the scene and get the ball rolling. If you take away anything from today’s missive, then it should be this... managing risk effectively is about making informed decisions in the face of uncertainty. It’s about reducing the impact of negative outcomes, but still enjoying the chance of positive ones. It’s about ensuring long term sustainability of your wealth. It’s about building sensibly for the future. It’s a framework, a paradigm, for how to think about the world you live in. Once you ‘get’ risk you will think differently. You will approach problems with a different philosophy. Your world will be enlightened. Intrigued?
If I told you there was an 80% chance of rain sometime tomorrow where you are, how would you react to that information? What does 80% mean to you? I guess you would think that, on the balance of probability, it is more likely than not to rain tomorrow and therefore I should prepare accordingly... hence wear some rain gear and leave the house with your umbrella. Perhaps postpone the barbeque you had planned? But here’s the thing. When we get to tomorrow, it will either rain or it won’t. That is to say, you will either experience a state of the world where there is rain or it stays dry. One thing you certainly won’t experience is 80% rain. What would that even look like? So going back to the previous day, what did that 80% actually mean? It was Keynes who said that it is meaningless to think of the world in probabilistic terms... because you have no way to use that information. It doesn’t help you determine what the weather will turn out like tomorrow. Obviously if there was an 80% chance of rain, then there was a corresponding 20% chance of it staying dry. But just because something is unlikely, doesn’t mean that it won’t happen (another way to interpret 80% is that four days out of five it would rain, and on one it would stay dry…). Sods law dictates that if you do cancel your barbeque it will turn out to be a lovely day. Feel stupid? Was the forecast wrong? The general point here is that the future exhibits uncertainty simply because it hasn’t happened yet. And with uncertainty comes risk. But what does it actually mean to say there is risk? In order to try and unravel this weather mystery a little further let’s take a step back and try and break down a few truths about our friend risk.
Evil Kneviil was a risk taker back in the day. You probably don’t know who I am talking about – well before your time, but look him up and you’ll get the gist of what he was about. Definitely a risk taker! And so too I would add was Neil Armstrong – clearly you need to be of a certain disposition in order to be the first person to take a step into the unknown. In your daily life, you are probably all too familiar with your own penchant for taking risk... ok, we don’t all dive off cliffs or go into space, but decisions you make every day contain some form of risk. Why is that? Simply due to uncertainty... we don’t know what will happen in the future – and that means we have to make informed decisions knowing that we won’t always be right (that is, know the outcome before we decide on a course of action).
When we talk about risk in the everyday conventional sense, there are two normal uses to which it is applied. As in:
“wow, that looks really risky, I’m not sure I want to do it”
and
“wearing a helmet whilst cycling reduces the risk of serious head injury”.
The former is synonymous with danger, and is subjective by nature - one person’s risk is another’s excitement. The latter is synonymous with chance, or possibility, and is generally objective by nature. When using the term as an expression of chance, we are simply acknowledging that in a situation where anything other than pure certainty about the future exists, there is (by definition) uncertainty about what will happen (i.e. in most cases, for most decisions, most of the time). But it could be good or bad – there are possibilities. It’s usually an objective assessment of a range of potential outcomes that could occur. That’s different than the more common use of the word risk, as in the former sense... and certainly I would hazard a guess that your experience would be to think of risk more usually as synonymous with danger. When we think about our daily lives, risk in this context usually revolves around a lack of control in a situation leading to opportunity for harm, injury or death, or more simply, just a negative outcome that we would prefer not to experience. In this sense it is much more of a subjective term. Clearly both uses of the term are heavily related but there is a subtle difference. Chance allows a full range of outcomes and is necessarily objective in that no degree of control is associated with the possible outcomes, whereas danger focuses on negative outcomes, and is clearly necessarily subjective.
So we can therefore think of risk as either ‘danger’ or ‘possibilities’. So far so good. Let’s expand on the idea of danger a bit though. Why would anyone even entertain exposure to risk, if that means injury, harm, or even death? Of course, there must be something in it for you. That’s the thrill and feeling that comes from the adrenaline flow, the heightened sense of living that often accompanies such activities, or, more mundanely, just a benefit that outweighs those perceived risks. So most people need to be compensated adequately (receive a return) to take on risk. The question will be how much risk is acceptable to take for the given outcome I expect to occur? And in these situations there is an interesting trade off that takes place... for any activity where you are exposed to risk, your default behaviour is to try and minimise the amount of risk required to achieve the goal you want (or potentially to maximise the benefit for a given level of risk taken). So you want the adrenaline rush from jumping out of a plane? Fine, but just make sure that you have a parachute attached (that has been checked), and that you know how to use it! You can’t remove the risk completely, jumping out of a plane is clearly inherently dangerous, but you can certainly reduce that danger by taking precautions. You will take as many precautions as you possibly can to reduce the risk whilst still being able to experience the thrill and rush of the event. So risk (danger), and return (benefit), are always together, hand-in-hand. The only question is how much of the former will you accept to experience the latter. It’s a trade-off you make each and every day in almost everything you do... you just don’t necessarily actively think about it. Need to drive to work? Risks: traffic accident, car breaks down, traffic delays. Benefits: save time, more efficient for you, more relaxing... who knows, but the point is even something simple like driving a car engages this trade off. For most people taking the car wins because the safety improvements have reduced the large negative outcomes to be so unlikely as to not worry about (note, still there, just much reduced).
So uncertainty about the future leads to risk (and excitement! ). Fine. The fact that the future is in front of us and yet to happen means we can’t know for sure what tomorrow will look like. Returning to our weather analogy at the start of this Letter, we can now apply a few of the concepts we have put down to help us think about what it all means. Firstly, there is a big difference between probability and outcome. Unlikely things happen all the time. You should try to think of the future not as a fixed outcome destined to happen and capable of being predicted, but as a range of possibilities, any of which are capable of occurring, but only one of which will come to fruition. As time evolves, the dynamic nature of the world means we need to continuously assess the current state and adjust our view accordingly. Things never stay the same. With a basis of insight into respective likelihoods, we can tailor our actions accordingly. So if there is an 80% chance of rain tomorrow, prepare for the likely occurrence of rain, but don’t be that surprised if it turns out dry. Don’t assume it WILL rain and absolutely don’t prepare for a world of certain rain. Managing risk in this context means assessing the impact of both rain and no rain and having plans for both outcomes that can be implemented once the time comes. Clearly with an 80% chance you can focus your plans on the rain outcome, but the point here is you mustn’t ignore the other possibilities and you mustn’t assume that you know how things will turn out. More broadly you should live with the assumption that many things can happen and always plan for multiple outcomes in any situation. Your experience will allow you to attach likelihoods to potential outcomes over time but never forget that at any point in time, lots of things can happen in the future, even if only one will actually happen. Embrace the uncertainty. Don’t strive to make the world a certain future.
So the next time you see a weather forecast predicting 100% certainty of rain, you can note the irony of the message it contains and not be (as) surprised if you wake up to beautiful sunshine the next day!
We haven’t broached the investment implications yet –there’ll be much more on that topic to come in subsequent Letters. For now, just remember that the passage of time induces uncertainty in everything we do. Uncertainty leads to risk, and risk itself is synonymous with chance and danger. But ultimately we bear risk because we believe the (positive) return outweighs the potential (negative) downside.
D.