Risky Business, Part 2

Welcome to Money Buff! Feel free to check out my other posts, and follow me on Twitter for more regular thoughts. For fresh insights into all things finance, subscribe here:

This post concludes a two-part series on the topic of risk, both in investing and life. If you missed part one, you can catch it here.

Here's the TLDR:

1. The risks that we talk about are rarely the most important.

2. Fast risk bites quickly with an all-consuming feeling. Getting into an accident from texting and driving is a fast risk with immediate feedback right in front of our eyes. We can see the consequences of our actions.

3. Slow risk doesn't bite in any obvious way. It's more subtle, like heart disease. It's a malaise that creeps up with no warning. Feedback on our choices isn't seen or noticed for months or even years.

The interesting thing about risk is that it's not just about the possibility of things going wrong; it's also about how ready we are to handle them when they do. That's why the biggest risks are often the ones that nobody is talking about. If nobody is talking about them, then nobody is prepared for them.

Appreciating these unknowns is half the battle when it comes to dealing with risk. The world is full of things we can't predict, and that's just the essence of life.

Let's revisit the skiing example from last week. Everyone knows someone who doesn’t wear a helmet because they “don’t fall”. But it's not about skill level, it's about appreciating the unknowns. We wear helmets not because we expect to fall, but because we know that accidents can happen. Think of it like this:

- The risk of hurting yourself skiing is reduced by wearing a helmet.

- The risk of hurting yourself skiing is raised by not wearing a helmet.

- The risk of hurting yourself skiing is zero if you stay in the lodge. But that’s not fun, and we want to have fun. Thus, we wear a helmet.

Comedian Louie CK hilariously illustrates this point in one of his old standup routines, where he compares his attitude toward safety in his own car vs safety in a taxi:

It's true, has anyone ever worn a seat belt in a cab? The seat belt represents our management of risk. When we think a situation is under control, when we think it feels safe, risk is thrown to the wayside.

If something does go wrong, not only are you exposed to a risk you hadn't considered, but the surprise alters your perspective in a way that creates unpredicted reactions.

It's why we don’t invest in protective measures until after tragic events occur. Homeowners invest in security systems after a break-in happens. Communities invest in bike lanes after a rider is struck. This phenomenon explains the entire history of the airline industry. It’s a maddening aspect of life. We intuitively know that owning a home and riding a bike comes with risks, but it takes the risk playing out to see it.

One might challenge the skier who doesn't wear a helmet by saying, well what if you do fall? What if ice comes out of nowhere? What if you lose control and hit a tree? What if someone else is out of control and hits you?

"I'll stabilize myself before I fall. I'll avoid trees and ice and look out for reckless skiers." That all sounds nice, but the whole point of risk is we don't know what is going to happen. Sugarcoated logic is the most enticing logic.

The same principle applies to investing. In a recession, we may think we'll follow Rothschild's "buy when there's blood in the streets," but the reality is often very different. The difference between thinking what a recession will feel like versus what it actually feels like couldn't be greater.

The easiest way to think about markets in a recession is in a vacuum, where all else is equal besides stocks which are 25% discounted. This is the sugarcoated logic.

It's much harder to think about markets in a recession caused by political unrest, a credit crunch, an oil embargo, or a pandemic. Something that makes it nearly impossible to hold onto what you already own, nonetheless buy more.

It serves as a reminder that investing requires not only expecting a sugarcoated runway to freedom, but also an awareness of how you'll react to the unexpected.

It's important to pay attention to known risks, but we should also realize that what we aren't talking about and thus aren't prepared for will likely be more impactful than what's known.

— Sam

If you liked this, add your email below to receive new posts!