Being wrong, missing out, volatility, permanent loss…risk gets defined too many ways. It’s true, and yet, risk is a little more complex than a simple definition when uncertainty is involved.
After reading through a few dozen pieces from Peter Bernstein, I’m fairly sure he had risk figured out as best as anyone can figure it out. Though he doesn’t offer a simple definition for risk – the first highlight below is a great soundbite to add to the list — he does deliver a better way to think about it in a broader sense.
What follows are some of Bernstein’s thoughts on risk that stood out most in what I read.
The biggest risk is not knowing what you are doing.
The derivation of the word “risk” reaches back to the early Italian risicare, which translates as “to dare.” Risk looked at from this viewpoint is a choice rather than a fate. For a true long-term investor, the choice, by definition, must be survival, or you can forget that long-term stuff.
Volatility matters on only two levels. First, if two portfolios have equal average returns, the portfolio with the lower volatility will earn the higher compound return. On the other hand, investors understand this phenomenon — either intellectually or intuitively — and tend to price volatile securities accordingly. The second consideration in volatility is much more important: when is the owner of the principal of the fund going to disburse that principal? A fund that is tied up in perpetuity could fluctuate all over the place without any consequence whatsoever. It is my impression that too many funds with long horizons are managed as though they were going to be disbursed in the next couple of years, largely because volatility makes people uncomfortable — which is irrelevant to the conditions on which a rational decision should rest. Fear of volatility can be costly to long-run returns and can unnecessarily constrain the freedom of managers to do their best.
On time dimension of risk.
I once had the unusual experience of hearing Henry Kissinger give the identical speech within just a few months. Nothing lost: His central point is so important that it justified a second hearing.
We must learn to act, he argued, before we have complete information. By the time all the information is in hand — if it ever is — the odds are high the moment will be too late for us to act…
Risk has a time dimension, which means procrastination inevitably transforms the nature of the risks we face. I do not mean to suggest that procrastination is inherently the wrong choice. Selling a stock because analysts forecast rotten earnings this year incurs the risk that results this year are only a short-term deviation from a firmly established longer-term growth path. Times cures many ills. But ignoring the earnings results for this year makes no sense unless we have confidence in our information beyond the short term.
A preference for such hopeful longer-term information can come in only two forms. Regression to the mean (and a benign mean at that) is the way the future works, or we have spotless crystal balls. Either of these requirements may be tenable, but we had better be aware of what we are assuming before we procrastinate.
That is not all. With time, probabilities of most outcomes become attenuated. We may assign a probability of 60% to Outcome A today, but what will be the probability of Outcome A six months from now? Worse, the passage of time may create other outcomes we cannot even visualize today, and those outcomes will tend to squeeze down the probability of the outcomes we believe we do know something about. Outcome A could be irrelevant in six months…
The point at which probabilities thin out is the point where risk blends into its senior and unattractive partner, uncertainty. Or, to put it differently, this is the point where we cross the Rubicon running between the short term and the long term.
It is a cliche to say we cannot ever read the future, but the effort to locate the critical point between information we can trust and information we can only guess at is an indispensable ingredient of successful investing. There are, I will admit, occasions when we are convinced the short-term news is only noise and the real information is in longer-term trends. But the difference is a mirage: We must still distinguish between trusting and guessing.
On risk management.
Risk means the chance of being wrong — not always in an adverse direction, but always in a direction different from what we expected…
RISK management, then, should be a process of dealing with the consequences of being wrong. Sometimes, these consequences are minimal — encountering rain after leaving home without an umbrella, for example. But betting the ranch on the assumption that home prices can only go up should tell you the consequences would be much more than minimal if home prices started to fall.
In this assumption, the word “only” is ridiculous. There are no “onlys” in the future. More things can happen than will happen.
Under those conditions, risk management should concentrate either on limiting the size of bets or on finding ways to hedge the bet so you are not wiped out if you take the wrong side — if home prices do start to go down, or even stop rising. Risk management is fundamentally different from managing volatility, which is how many investors view it. Volatility is often a symptom of risk but is not a risk in and of itself. Volatility obscures the future but does not necessarily determine the future.
Someday I’m going to write a piece called “The Perils of Brilliance.” The times I have been most wrong are the times I thought I was most right. You asked me at the beginning about the things I’ve learned from all of this, and I have to repeat: It’s humility. I think the reason I’ve been able to survive 55 years in this business is because I developed humility… It’s the only way to survive — not necessarily to be the top quartile — but survival is really the name of the game we’re playing with long-term considersations.
On the “long run.”
While we can learn from the long run about how bonds and stocks respond to changing environments and to each other, the long run can tell us perilously little about what kinds of environments lie ahead. On that point, I maintain, we have to accept uncertainty rather than fight it: we must rely more on judgment than on econometric models. I agree with Nobel Laureate Kenneth Arrow that “Our knowledge of the way things work, in society or in nature, comes trailing clouds of vagueness. Vast ills have followed a belief in certainty.”
On the lesson of history.
The constant lesson of history is the dominant role played by surprise. Just when we are most comfortable with an environment and come to believe we finally understand it, the ground shifts under our feet. Surprise is the rule, not the exception. That’s a fancy way of saying we don’t know what the future holds. Even the most serious efforts to make predictions can end up so far from the mark as to be more dangerous than useless…
All of history and all of life is stuffed full of the unexpected and the unthinkable. Survival as an investor over that famous long course depends from the very first on recognition that we do not know what is going to happen. We can speculate or calculate or estimate, but we can never be certain. Something very simple but very penetrating stems from this observation. If we never know what the future holds, we can never be right all the time. Being wrong on occasion is inescapable. As the great English economist John Maynard Keynes expressed it some 80 years ago, “A proposition is not probable because we think it so.” The most important lesson an investor can learn is to be dispassionate when confronted by unexpected and unfavorable outcomes.
A Modest Proposal – E&P Strategy
How Long Can You Run and Where You are Running? – E&P Strategy
The 60/40 Solution – Bloomberg
A Conversation with Peter Bernstein – Journal of Investment Consulting
What Happens if We’re Wrong? – NY Times
The Time Dimension of Risk – Journal of Portfolio Management