Introduction to Risk
This is Peer. His Twitter handle is @peer_rich.
Peer is a good founder, entrepreneur, and human.
- He is a role model and leader for transparency and disclosure for all startups.
- He is disrupting calendars: a tech category at the heart of our timing needs.
- He is a champion of open source, open hearts, and open mind.
Peer woke up yesterday and all of his back accounts were frozen.
Not just this, his vendor’s bank accounts were also frozen.
It’s like the entire monetary system around him was gone.
What does frozen mean? Who can even tell us? JP Morgan isn’t cool these days.
This is what we expected from crypto. But not from share price dollars.
Peer then tweets out loud, our biggest collective economic fears.
Peer is left with no good economic choices.
All choices lead to bad outcomes.
Anxiety for sure, Return no more.
What is Risk?
Glad you ask. Let’s borrow some neat slides from HBS and Morgan Stanley.
WIth some deep admiration for their pretty formatting let’s dive into the basics of Risk:
- Morgan Stanley thinks about Risk and Return in two fundamentally different ways.
- Then they combine both into one “Risk Reward Spotlight” chart for our analysis.
- Funamental approaches focus on three scenarios: bull, bear, and base cases.
- Quant approaches yield a continuous probability description of outcomes.
So basically Morgan Stanley assigns “equal probabilities” to all 3 bull bear and base cases. And we get the Risk Return Spotlight charts as below for equity stocks!
Voila, the magic of Fin!
- The blue fractal line represents the History of share price over the last two years.
- The blue triangle represents the Future of possible share prices over the next year.
- The three dots at the end of this shady triangle represent scenarios of bull, base, and bear cases OR good, bad, and ugly.
But did you notice what they have observed?
Human conviction has a tighter range and better skew than the three rational scenarios of bear, bull, and base cases.
To illustrate this we focus on the text above triangles below:
We observe how the deeper blue triangle is carved out of the lighter blue triangle of possibility space, but it has a tighter range. We note how the third triangle is actually made up of two different green and red triangles, and it has better skew because the red triangle is almost invisible.
So they narrow this range down,
using arbitrary feels and,
segment this up using,
To explain this in simpler Greek, let’s start with the two wise observations by Morgan Stanley:
- Human’s see the future as a subset of total rational possibilities, leading to ‘tighter ranges’ on their risk return charts. Deep Blue.
- Human’s label and categorise outcomes into either good or bad, leading to ‘better skew’ on their risk return charts. Green and Red.
Skipping Greek to save time. Let’s simply borrow some jargon from behavioral economics.
- Optimism bias: the assumption that the future will be a subset of the rational possibilities that are favorable to us.
- Labeling bias: the categorization of outcomes into either “good” or “bad” based on our subjective perceptions and biases.
Complex Risk Spotlight
Herbert Simon – 1978 – Bounded Rationality Herbert Alexander Simon was an American economist, political scientist, and cognitive psychologist who received the Nobel Memorial Prize in Economics in 1978 for his theory of “bounded rationality”. His interdisciplinary research spanned across the fields of cognitive science, computer science, public administration, management, and political science. Simon’s theory of bounded rationality explains that humans make decisions that are rational within the limits of the information and time available to them. It also argues that human rationality is limited due to our cognitive and experiential limits as humans. Bounded rationality is a fundamental departure from classical economic theory, which assumes that people have perfect information and are able to make completely rational decisions.
Bounded rationality has had important implications for the field of behavioral economics, which seeks to understand how people actually make decisions, rather than how they should make decisions according to classical economic theory.
By better understanding the cognitive limits of decision-making, policymakers and businesses can design interventions that nudge people towards making better decisions. For example, simplifying complex financial information or offering default options that align with people’s preferences and goals, can help them make better decisions in areas like personal finance or retirement savings. Then someone decides to use pension money for alternative investing in a progressive asset class.
Now before we can understand the Risk Return Spotlight chart, we first need to understand the biases that shape how we perceive our collective future. We need to understand the observers of these charts: ourselves.
Humans See the Future Through Biases
Humans have cognitive biases that shape their perception of the future.
One such bias is the optimism bias, which leads us to assume that the future will be a subset of the rational possibilities that are favorable to us. Despite there being no real reason for this optimism, we continue to hold onto it, as it offers us hope, and a sense of control over our lives. Reality is mostly shaped by the optimists, while the pessimists are cribbing, and the realists are busy suffering.
Humans also feature labeling bias, which involves categorizing outcomes as either “good” or “bad” based on our subjective perceptions and other interesting biases. This bias can lead us to overlook potential risks or overvalue certain investments based on our preconceived notions of what constitutes a “good” outcome.
At their core, the optimism bias and labeling bias reflect deeply ingrained human desires for control and certainty. We want to believe that we can predict and control the future, even though this is often not the case.
Price Is Both Right and Wrong
In the context of financial market theory, good and bad make up a neat zero-sum game. Then we play this remarkable game called the price is right!
Some humans agree with the triangles and dots. Others disagree with the triangles and dots. Most trade based on this chart for upside. Some of them win and they call it Return. Some of them lose and they call it Error.
Market participants place their bets in the blue areas of possibility space based on their conviction. Conviction is a belief that is not held too strongly or too weakly, but rather held on the margins. This thin line is where the strengths of our beliefs exceed the difficulty of our actions.
Risk and Return are Inseparable
Nobel prizes have been awarded to theories that encourage the idea of tighter range of control as always being better, perpetuating this belief in the finance industry. However, with the inherent biases and uncertainties that exist in financial markets, it is important for investors to acknowledge and embrace risk as an inherent part of the investment process.
Risk and return are inseparable concepts in investing. Investors must embrace risk and have the ability to understand and assess it in order to generate returns. By acknowledging risk and incorporating it into their decision-making process, investors can make more informed and rational decisions, avoiding the pitfalls of biases and cognitive errors.
This requires a shift away from the traditional idea of rational decision-making towards a more nuanced understanding of the cognitive limitations of decision-making and the importance of embracing and measuring risk.
Imaginary Risk Spotlight
Gary Becker - 1992 - Motives and Consumer Mistakes Gary Stanley Becker, an American economist and professor of economics and sociology at the University of Chicago, received the Nobel Memorial Prize in Economic Sciences in 1992. He is considered the leader of the third generation of the Chicago school of economics, and his work extended the domain of economic theory to aspects of human behavior previously dealt with by other social science disciplines such as sociology, demography, and criminology. Becker argued that various types of human behavior can be seen as rational and utility-maximizing, including altruistic behavior. Becker's approach included defining individual's utility appropriately to incorporate altruistic behavior as part of human behavior.
The concept of pricing risk has been an integral part of human society for centuries and more. It gained more attention during the Renaissance period when wealthy families in Italy used the practice of insurance to hedge against financial loss from their commercial ventures.
Historically, risk was managed through various mechanisms such as diversification, spreading risks across different assets, and hedging. However, it was only in the 20th century that the idea of pricing risk formally entered the world of finance, with the advent of modern portfolio theory and the Capital Asset Pricing Model (CAPM).
In the mid-1950s, Harry Markowitz developed modern portfolio theory, which introduced the concept of diversification in portfolio management. Markowitz proposed that by investing in a diversified portfolio of assets, an investor can reduce risk without sacrificing returns. This theory was later refined by William Sharpe and others, who introduced the CAPM, which describes the relationship between expected return and risk.
CAPM introduced the idea that investors are compensated for taking on risk in the form of a risk premium. This risk premium is the additional return an investor expects to receive for holding a risky asset compared to a risk-free asset, such as a government bond. The risk premium is determined by the asset’s beta, which measures the sensitivity of an asset’s return to the overall market.
So now, there is a globally accepted common model for all rational risk takers: the Capital Asset Pricing Model. What could go wrong? In the world of finance, just like in modern physics, reality is often far more uncertain and unpredictable than our collective greed and fear would like to admit.
The Only Problem?
It assumes that this universe is a simulation and everyone thinks like Chat GPT. Following are the foundational imaginary assumptions made by the CAPM model:
- Risk and return are linearly related.
- All investors are risk-averse by nature.
- There are no taxes, inflation, or transaction costs.
- Investments can be divided into unlimited pieces and sizes.
- Investors have the same time period to evaluate information.
- There is unlimited capital to borrow at the risk-free rate of return.
Daniel Kahneman and Amos Tversky - 2002 - Prospect Theory and Anchoring Bias Daniel Kahneman is an Israeli-American psychologist and economist, notable for his work on the psychology of judgment and decision-making, as well as behavioral economics. Along with Amos Nathan Tversky, a cognitive and mathematical psychologist, Kahneman was awarded the Nobel Memorial Prize in Economic Sciences in 2002. Their prospect theory explains that losses and gains are valued differently, and individuals make decisions based on perceived gains instead of perceived losses. The anchoring bias, also developed by Kahneman and Tversky, states that people tend to rely too heavily on the first piece of information they receive when making decisions. Their empirical findings challenged the assumption of human rationality in modern economic theory, and their Prospect Theory assumed that losses and gains are valued differently, leading to decisions based on perceived gains rather than perceived losses. Also known as the "loss-aversion" theory, this idea highlights that individuals tend to choose the option that presents potential gains rather than possible losses.
More recent Nobel prizes have been awarded to show that the theoretical idea of complete control over risk is virtually and mathematically impossible.
Risk is a fundamental concept in finance that can be difficult to define, yet it is essential for any investment decision. It is often confused with uncertainty. In reality, risk represents the imminent potential for negative outcomes to arise, stemming from the certainty that possibilities will be different from our expectations. Risk is certainty about the uncertainty of our plans.
When looking forward in time, risk is the conviction in future possibilities to generate returns. We take on risk in the hopes of greater returns, also known as “greedy risk.” Sometimes we take risk for the thrill of it, but our return function will typically account for this factor.
On the other hand, when looking backwards in time, risk is the conviction that past possibilities generated low returns. This type of risk is known as “regret risk” since it reflects our regret for not taking more risk in the past.
Finance is plagued by a fundamental problem that can be summarized in two simple concepts: risk and return. Unfortunately, these two ideas are closely intertwined, and form the foundation of modern financial theory.
Firstly, it is important to recognize that there is no return without risk. In order to generate a return on an investment, one must be willing to take on some level of risk. This is because the potential for gain is always accompanied by the potential for loss. It is this tradeoff between risk and return that lies at the heart of finance.
Secondly, it is a well-known fact that market participants want more return for less risk. This is the driving force behind much of the investment decision-making that takes place in financial markets. Investors are constantly searching for ways to maximize their returns while minimizing their risk exposure. This pursuit of higher returns has led to the development of sophisticated investment strategies and financial instruments.
This is because different investors have different risk preferences and investment objectives. For example, a conservative investor may be satisfied with a lower return if it means they can avoid significant risk. On the other hand, a more aggressive investor may be willing to take on greater risk in order to achieve a higher return.
Real Risk Spotlight
Robert J. Shiller – 2013 – Analysis of Asset Prices Robert James Shiller is an American economist, academic, and best-selling author, serving as a Sterling Professor of Economics at Yale University. In 2013, Shiller was awarded the Nobel Memorial Prize in Economic Sciences for his contributions to the empirical analysis of asset prices. Shiller’s work in the field of behavioral finance views finance from a broad social science perspective, including psychology and sociology. He found that a significant market anomaly that efficient market theory fails to explain is excess volatility, which challenges the idea that asset prices can be forecasted using the present discounted value of future returns.
The global financial crisis of 2008 highlighted the importance of accurately pricing risk, with the failure of many financial institutions attributed to a lack of understanding of the risks associated with complex financial instruments. In response, regulators introduced stricter risk management requirements, such as stress testing and risk-based capital requirements, to prevent a similar crisis from happening in the future.
But not much changed. So what is Risk?
Conclusions to Risk
It’s those darkest shades of blue in all our charts that go unnoticed.
Until 2010, many financial services organisations had blue logos.
Blue was choosen as the color to communicate trust, reliability, and consistency.
Then the collective unconscious perception of blue was hijacked by another industry.
And everyone kind of learnt that signalling but not financial services.
Why should this even matter?
For example, take this blog and the choice of colors and font. Should you believe what this blog writes simply because it is blue? Nope. Trick question. It does not matter what we believe.
I strongly believe that all humans are collectively super rational. It’s just that sometimes, our Local Rationality is different from Global Rationality. So it appears to the naked eye as groupthink but it is really not.
What matters is if we can measure Risk better next time.
Richard Thaler – 2017 – Predictable Irrationality and Nudge Theory Richard H. Thaler, an American economist and professor at Chicago Booth School of Business, was awarded the Nobel Memorial Prize in Economic Sciences in 2017, for incorporating psychologically realistic assumptions into analyses of economic decision-making. Thaler’s “nudge theory” proposes positive reinforcement and indirect suggestions as ways to influence the behavior and decision-making of individuals or groups. Thaler’s work in behavioral economics shows how human traits like limited rationality, social preferences, and lack of self-control systematically affect individual decisions as well as market outcomes.
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