We’re all risk managers now

Dan Mikulskis writes that investing over the long-term is all about balancing risk: there are always hundreds of risks that could damage your portfolio or throw you off course, but hedging them all ends up with you stashing cash under your mattress. And we know there’s good evidence that investing “works”, over long periods in spite of – or perhaps because of – the risks.

When exploring the terrain of the area between the extremes, risk management is a key discipline and language to guide us. So potentially we have a lot to learn from risk managers and risk economists right now. Of course, we’re all inherently wired to dislike uncertainty and to try and remove it. But it’s not always possible, or at least avoiding uncertainty often comes with a heavy cost in itself, which we need to think hard about before paying. It’s risk management that lets us navigate uncertainty sensibly.

Renowned risk author and economist Allison Schrager has a simple but powerful model for how to manage risk.

1. Get clarity on the objective against which you are measuring risk. It is worth remembering in day to day life we run all sort of risks leaving the house or getting in a car each day, so zero risk isn’t a reasonable objective. In investing the mistake is often to confuse a long-term income-generating objective for a short-term wealth preservation objective
2. Use risk models for what they are worth, focus on communicating results well using natural frequencies rather than percentages. Particularly relevant now, of course, helping people understand their own risks (and those of the people around them), and how these vary by age and other factors is tough, but arguably never been more important.
3. Understand how you can diversify, spread your risks/avoid concentration of risk, and do this as much as you can in your situation
4. Figure out what hedges you have at your disposal, and how much these cost you to implement. A hedge is a position that gives an offset to an existing position, so you get an offset on both upside and downside.
5. Figure out where you can deploy insurance (pay away a fixed cost to take away your downside, but you keep the upside). Insurance usually has to be put in place in the good times to work in the bad times. Fire and flood insurance get bought after fires and floods, but the next crisis won’t look the same as the previous.
6. Deploy a suitable mix of hedging and insurance strategies to help manage your risks.
7. Put resiliency into your plan so that you can keep going even if something totally out of the ordinary happens. One big challenge in building resiliency is that it has a cost, it often runs counter to optimisation and looks like inefficiency in the good times. Profit-maximising firms will struggle to build resiliency.

If you follow these steps you’ll be in a better place by judging any plan against the right objectives. Insurance, hedging and resiliency all come with associated costs, so don’t jump to paying away too much for certainty – you’ll want to explore the combinations of these approaches that can get you to an expected outcome you can live with, not forgetting to make sure that you see how far diversification can get you before you start paying for the additional certainty of insurance, hedging or resiliency.