Good news! The Dow is at record highs, companies are merging and acquiring more, and lots of people were hired last month!
Though, there is more. Europe is still stuck on self-flagellation. Tremors in the Middle East continue; you could make points about China and Japan, too. Plus, Washington’s only focus is on innovating the harm it inflicts on the country. Professionals, that lot.
The good news is actually strange news…from a macroscopic perspective, you might say, Eh, same ‘ol situation, no? So – what the devil is going on?
I haven’t the slightest clue! But I’ve heard recently that tail risk is down, and that investors are back in Risk-On Mode…
Jeez. Have we resorted to so little in the way of analysis? Investors have shifted to a risk-on mentality? Uh, I hope we can do better than: Something went up, so something turned on. Let’s just refuse these cheap observations; much too tedious, and deeply flawed. (And if point is about correlation, say that!)
Unfortunately, the flaw runs deep. Speaking of Risk On/Risk Off doesn’t just waste time by saying nothing. It also mangles our understanding of the process of taking risks. I’ll tell you why.
But first, humble and patient reader, allow me to slake my appetite for a meditation on risk. It'll be something of a scenic stroll, I promise.
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What is risk? The potential for harm, you say; the imminence of danger. I agree. Risk implies something bad might happen. How about this: risk, then, implies existence, because it entails something is there to be harmed. It could be your body, or it could be your bank account. Either way, risk means phenomena.
In a crude but fundamental way, life itself, that blip of light in the infinite dark, is simply exposure to death. Turns out the potential to die is no mere attribute. It is life, defined. And so: Life is risk. Similarly (but not too similarly, I hope you’ll agree), money is risk. Money in all forms carries risk; the only riskless asset is one that does not exist.
Okay, I agree, that’s not so profound. My hope is to emphasize that all of life is dealing with risk, and, in finance, every asset presents risk. We don’t choose to deal with risk. By living, we simply must.
Well. Broadly, that effort is twofold: First, we must evaluate riskiness – the extent of danger or potential harm (often estimated probabilistically). Second, we determine our risk appetite – how much of that danger we fancy.
Step one is extremely difficult to do accurately, in general life and in finance. And step two requires some reflection. But conflating these two operations is not difficult to avoid, and yet, alas, it is a ubiquitous mistake. Shall I bungee jump? Shall I buy some AAPL? Each question has two parts: how much risk is there? How much do I want?
Anyway, let’s return to the cheap observation from above – that Investors are demonstrating a risk-on mentality in 2013. What does this tell us about how investors are taking risks? Not much.
Risk-on sounds as though investors demand more risk. That makes sense, and is perhaps likely – central banks, at least, have made enormous effort to encourage investors to take more risk. But appreciating equities could also imply investors estimate risk is lower, while maintaining the same risk appetite.
And, of course, the reality is probably some blend of the two. But the difference is significant enough: demand for US equities driven by demand for higher risk suggests a different vote of confidence than if equities appreciate because they are estimated to be safer.
The point is simply that Risk-On/Risk-Off observations ignore this distinction. And the distinction is important: are investors becoming more frenzied, or do equities seem safer?
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If I were nerdy and you were unlucky, I'd even say the two steps are dialectical. The operation is self-influencing: because step one (how much risk does a given opportunity present?) will always carry some uncertainty, step two (how much risk do I want?) must incorporate the confidence in step one’s answer. If you think bungee jumping or buying AAPL carries moderate risk, and you demand moderate risk, you might yet move on because your confidence in your estimation is low.
This is obvious, and I apologize for boring you. Among many others, only louder, Nassim Taleb's been inveighing against the confidence risk managers have in their risk estimations. That hubris is a frightening problem. Many people make the mistake before arriving at the office, simply by thinking they are measuring as opposed to estimating risk.
Risk estimation, which is usually done probabilistically, often creates the unfortunate chimera of precision. That is a misunderstanding of probability. I’m no true expert (my skepticism notwithstanding), but I’ve studied and practiced enough to see that probabilities are expected (estimated) frequencies of possible events. Although probability functions provide exact numbers, the entire effort behind probability mustn’t be forgotten: it is a stab in the dark - though an informed, rigorous one – no matter what Nate Silver says, because it introduces parameters to reality. That’s the only way it works – and works can only ever mean, at maximum, moving from total darkness to the penumbra. Probability theory works especially well in games (black jack, baseball) because the "reality" is already confined within only a few parameters (a deck of cards and the number 21; a hit or a strike, to name four). For more on this point and other marvelous arguments, I encourage an hour listening to Cathy O'Neil on EconTalk, and then perusing her blog. One finds oneself ululating.
There is much more to say – and fortunately for you, more eloquent and seasoned people have done so.
Let’s end this saga with the following irony. Taleb’s proposal for dealing with lack of confidence in risk estimations is to allocate investments following a barbell strategy. Put a big chunk (the majority) on the safest end of the spectrum, and a minority portion to the riskiest end of the spectrum. This tactic stands in opposition to the belief that allocation should be concentrated in moderate risks. In that case, Taleb thinks, you end up picking up pennies in front of a steamroller. You can only have so much upside, while you'll always hear the susurrus of potential downfall in every shadow, as so much depends on the accuracy of your risk estimation.
Fair enough. The point is to minimize exposure to risk estimation errors. But is his the logical conclusion? Allow me to adumbrate Taleb’s argument:
- Minimize risk estimation error.
- The smaller the probability, the greater the estimation error is likely to be.
- So, Minimize the risks with smallest probabilities.
Wait a tick! We should all be investing in the biggest risks, where the probability of harm is large and therefore easier to correctly estimate!
I admit to finding that funny. You might not, but then, you have a life, and I have a blog. Of course, this is an oversimplification of Taleb’s point. The argument above must be balanced with other constraints.
But there is a kernel of truth. As a rule of thumb among others, this says invest according to a function of ignorance. There are small arbitrage opportunities that come with tough-to-estimate risk; picking up pennies ahead of a steamroller. For the prescient investor, this is manageable. For the ignorant one, this is a dangerous method. Better, perhaps, to go for the high reward, higher risk opportunities – for in those cases, the risks are easier to see.
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And what about your life outside investing? Well, the same applies – take more risk, and you’ll live more life! Just don’t die.