Inherently Dangerous Activities, Part 2

In part 1 I laid out a framework for thinking about risk in two contexts where it is fundamental to the activity — climbing and finance. In these contexts, risk is something that is managed, not avoided. In this post we’ll talk about risk management, and failures of risk management, in the real world.

Modern Portfolio Theory

Investment decisions by institutions used to be constrained by the “Prudent Man” rule. A prudent man invests only in prudent assets — high quality loans to high quality borrowers who can be expected to pay those loans back. Subprime loans and, god forbid, stocks, were not assets held by prudent men, but by speculators — and thus not part of a responsibly managed portfolio. This brings us back to Alex Honnold, a man who just recently completed one of the world’s highest and hardest rock climbs without any safety gear. Alex is not a prudent man.

It should be noted, however, that this is not Alex’s daily routine. He is a full-time climber but he spends only a small portion of his time climbing hard routes without protection. Alex is an all-rounder, and climbing has a variety of disciplines to accommodate anyone’s risk tolerance. On any given day, Alex may be sport climbing at a sunny roadside crag or climbing on the boulders around camp where he risks at most a sunburn or a sprained ankle. Alex Honnold doesn’t solo El Capitan every day — it’s not his whole portfolio.

Today we think about investment risk using the framework of “Modern Portfolio Theory.” The idea is that a given risk cannot be evaluated as prudent or imprudent on its own — instead, it matters how it fits into the overall portfolio. By controlling risk in the rest of our lives, we are able to make the occasional high-risk, high-reward investment. Investors buy stocks, bonds, houses, wine collections, and forests. Investments that would be imprudent on their own can diversify the portfolio as a whole. This mindset has allowed ordinary investors to participate in a broad range of financial activity — it has allowed climbers and other risk-takers to attempt objectives that were once the domain of daredevils and maniacs.

Innovation, Financial and Otherwise

Early climbers were an eccentric bunch. They had to be. Most mountains were first climbed with no safety gear at all and, even after they started using ropes and pitons, climbers lived by the rule that “the leader must not fall” — that is, the climber at the front of the group should avoid falling, as the equipment was unlikely to hold him. Anyone who wanted to climb mountains at that point had to accept the whole range of risk that entailed — it was not a very popular sport.

There are still disciplines of climbing that require a lot of risk; Himalayan mountaineers routinely struggle and occasionally perish on the highest mountains in the world. The sport as a whole, however, has diversified in ways that would be unrecognizable to its early practitioners. Climbing equipment has gotten stronger and safer, and techniques have improved in line. The advent and acceptable of bolts — fixed protection drilled into the rock — has opened up previously unthinkable terrain. In short, today’s climbers have far more, and better, choices than their predecessors. We don’t have to accept the whole set of risks that early climbers faced — we can pick and choose. That’s innovation.

In the same way, financial innovation is about connecting people with the risks they want to bear. In the past, an investor could call up her broker and buy 100 shares of stock in IBM. She may think that IBM will increase its dividend over the next quarter, or that computer technology is the future — or maybe she just wants a safe place to park her retirement money. Either way, the solution is the same — buy IBM. Yet IBM is a complex business affected by everything from consumer tastes to geopolitical events. Its stock is a residual claim on earnings after paying off more senior claims, mediated through a board of directors and management team, with some governance structure and voting rights and fitting into a larger legal framework. It’s a complicated basket of risks — some that the investor may purposefully seek to hold, and some that just come along for the ride.

The rise of mutual funds, exchange-traded funds, and derivatives have, at their best, allowed for more precise allocation of risk. An investor who wants to bet broadly on the success of large US companies can buy an S&P 500 index fund. This frees her from worrying about the idiosyncratic performance of IBM. On the other hand, an investor who is optimistic about IBM’s earnings this quarter can buy a short-dated call option around the announcement. In each case, the risks are being borne more precisely by the investors willing to bear them.

Where we go Wrong

Let’s revisit an issue I alluded to in part 1: despite advances in technology, equipment, and understanding of risk, we continue to make poor risk management decisions. Furthermore, these mistakes are not random — we are prone to the same biases across many domains. Climbing can be instructive here, because the emotional component is obvious — it’s hard for our rational brain to quiet fear when we’re dangling from our fingertips above the abyss.

This climber may be scared out of his mind, but the fall is relatively safe. He will just swing out into the air.

Consider the fear of falling. A “lead” climber is the first climber on the route; she starts at the bottom and places protection as she goes. If she falls, she falls down to her last piece of protection — and then past it, the same distance. If she falls when she is 5 feet above her last piece of protection, she will fall 10 feet in total.[1] The main risk in a lead fall is hitting something on the way down, so the most dangerous time to fall is when there is something to hit below you. In general, a steeper wall means a safer fall. The irony is that our fear response is exactly the reverse. It can be much scarier to climb a steep route with lots of exposure than a low-angle route with ample ledges on which to break an ankle.

This climber feels safe due to the moderate terrain. One slip, however, and he goes bouncing down the cliff, hitting every ledge along the way.

Risks are also misjudged in the investing world. The most conservative investors may buy gold or land or simply stuff their cash under the mattress. By avoiding the volatility of “riskier” assets, they may increase their risk of not having enough money in retirement. They avoid the pressing, salient, heart pounding risks — and end up with two broken ankles anyway.

Another reason risks are often misjudged, in finance and in climbing, is because of “fat tails.” This phrase refers to the distribution of likely outcomes; a distribution with fat tails is one where extreme outcomes happen more often than you’d normally expect.[2] In other words, when things go bad, they go very bad. The stock market can stay in a narrow range for a while before crashing. Likewise, climbers can go a long time without an accident — when something does go wrong, however, the stakes are high.

This distribution of risks is hard to grasp, and it leads to severe errors in both directions. On the one hand, sustained periods of calm with no bad outcomes can lead to complacency. Both climbers and investors in this situation may underestimate the probability of a catastrophic outcome. On the other hand, we may overreact in the other direction when a bad outcome finally happens. Climbers who’ve witness or experienced an accident can become crippled with fear — what was once a casual climb is now a reminder of everything that can go wrong. Our limited first-hand experience makes it hard to look objectively at the risks.

Focus only on the risks, and you miss out on too much.

Since I began this article with a disclaimer from the climbing world — “climbing is an inherently dangerous activity” — it seems that I should leave you with one from the investing world: “past performance is not an indicator of future results.” People have good or bad luck, and meanwhile the world changes around us. To infer safety from limited experience is to tempt fate. Investors, climbers, and all other brands of human would do well to evaluate and revaluate the risks we take every day. It’s a part of life.

[1] Plus the length that the rope stretches, plus any slack rope between the climber and the belayer, plus any distance the belayer moves when catching the fall. Phew!

[2] To get more technical about it, most financial variables have excess kurtosis relative to a normal distribution.