Risky Business, Part 1

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This week's post begins a two-part series on the topic of risk, both in investing and in life. In the first part today, I discuss skiing, the problem with forecasting, and the two ways we can think about risk.

Next week, we'll explore the fascinating ways in which we respond to these risks, and how we can better prepare ourselves for the future. Let's jump in.

There are relationships in the world of money which are inextricably linked. Risk and return are the most notable. We tend to understand this relationship in other areas of life, but not as much with finances.

It’s why ski slopes have green circles and double black diamonds. In exchange for more risk, you get a greater potential return. Return can be however you define it— more fun, a bigger thrill, or an overall feeling of accomplishment. On the other hand, risk is pretty self-defining. It’s what prevents us from achieving our objective.

If my objective is to have fun skiing down the mountain, risk is losing control of my skis and potentially injuring myself. But what is risk in investing? Just like when skiing, there's always a chance that you could fall and get hurt, but it’s less clear where the ice patches are hiding.

Markets are turbulent and the whole point of risk is we don’t know what’s going to happen. Each year, The Economist releases a forecast for the upcoming year. The 2020 edition does not mention anything about a pandemic. Similarly, the 2022 edition does not predict Russia's invasion of Ukraine. That’s not a criticism – both events were impossible to predict. No one did so. And that’s the point.

The biggest news, the biggest risks, and the most consequential events are always what you don’t see coming. As they say, the forecaster’s hall of fame has no members.

Risks can ultimately be split into two categories, fast risk and slow risk. I was introduced to this concept after reading one of Albert Wenger's blog posts on slow risks:

Fast risks are like a bolt of lightning, a singular event that seemingly appears out of nowhere and has immediate effects. They can change the course of our lives in an instant, creating a clear distinction between the way things were before and after the event.

Humans understand fast risk well because it was all we knew for millions of years. We've learned to associate strange noises and sudden movements with danger, a trait that has kept us alive to this day.

But even with our natural inclination to react to fast risks, we still find ourselves taking chances. Texting while driving is a prime example of how we underestimate the power of fast risk. In a split second, a single mistake can lead to devastating consequences. The fast risk here is the possibility of getting into a car accident, potentially leading to severe injuries or even death.

Fast risks also play a significant role in the world of investing. A market crash, for instance, can wipe out a large portion of your portfolio in short order. These types of fast risks can be hard to predict, leaving investors scrambling to recover their losses.

But not investing at all is a much different kind of risk. Let me explain slow risks.

Slow risks are the accumulation of small decisions that may seem inconsequential in the moment, but ultimately have a significant negative impact in the long term.

There's no single point in time you can look back on and say, "That's what did it." It's the cumulative, day-in and day-out decisions snowballing into an unwanted outcome.

Consistently investing in index funds over the course of decades has historically been the most reliable way to create wealth. Sure, you will encounter recessions and crashes along the way, but that hasn't prevented long-term investors from coming out on top.

Not investing your money for a year won't have a material impact on your long-term gains. But not investing over the course of decades may significantly impact your wealth.

Heart disease works the same way. Unlike a car accident or market crash, the disease doesn't hit overnight. It takes years of unhealthy lifestyle choices for it to manifest in a life-altering way. Smoking, eating junk, and not exercising for a year won't kill you, but do those things for a decade and you'll likely notice the toll it takes.

The danger of a slow risk lies in its subtlety. It's not until you're decades into the future that you can finally observe the outcome of your decisions. You can't see it in the short run, yet it's all you see in the long run.

This all makes sense when we again think about humans as civilized monkeys. Preparing for something that we can't see, can't feel, and can barely conceptualize just isn’t in our nature the same way fast risks are. Exercise is one of the best things you can do to prevent heart disease, but it's hard because voluntarily expending energy is the opposite of how we evolved.

In a world where unimaginable outcomes create the spread between expected returns and actual returns, understanding risk is crucial. Fast risks draw our attention with their immediate impact, usually in the form of headlines: Inflation, recession, supply chain, Elon. But it's essential to recognize the impact of small decisions over long periods of time, both in investing and in life.

Stay tuned for next week's post where we'll explore the fascinating ways in which we respond to these risks, and how we can better prepare ourselves for the future.

Catch you on the slopes.

— Sam

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