What’s the best way to reduce deaths from airplane crashes in the world?
Outlaw flight and ground all aircraft immediately.
Now obviously this is nonsensical, but hopefully illustrates that risk is not evil. It is a necessity of life and cannot be avoided. Therefore our best strategy is to manage it appropriately. Or in other words “Nothing ventured, nothing gained”.
Now when it comes to investing, how should we think about risk?
My strategy around risk is based on a lot of Nassim Taleb’s thinking and writings, and I think about risk in the following ways:
Never take a risk you can't recover from
Never assume you can accurately numerically quantify risk
Try and have large positive optionality
Never take a risk you can't recover from
Traditional risk management practice relies on the idea of expected value (EV) i.e. if there’s a range of possible outcomes of a choice you can calculate the expected value of the risk and if it’s positive enough it’s worth taking the risk.
I. e. if you have $10000 in total investments all invested in 1 company and you model 2 possible outcomes for that company.
Outcome 1: the company fails and you lose all your money.
Outcome 2: the company is massively successful and your investment goes up by 100x.
If we model the weights of each outcome being 50% likely. Then the expected value of investing would be. EV = (.5)(0) + (0.5)(100)(10000) = $50000.
Should you make this investment?
The answer is no or at least not with all your money. Even though the EV is hugely positive there’s a 50% chance of going bankrupt, and never being able to recover and make another investment. This is before even questioning how you generated these percent probabilities and whether there’s any reasonable validity to your numbers.
Never assume you can accurately numerically quantify risk
Quantifying risk is nonsense that Wall Street and portfolio managers engage in all the time. Things like Risk Adjusted Return. While on the other hand stating that “past performance does not predict future results”. People sleep better if they can attach numbers to things even if the numbers are meaningless and dangerous. The less sophisticated your investing strategy the more reasonable it probably is. The more math you have describing how great you’ve maximized the risk adjusted return of your portfolio the more scared I would be.
Try and have large positive optionality
It’s important to expose yourself to the possibility of things strongly going your way. i.e. would you rather have all your money invested in a mix of stocks and bonds with the most optimized risk adjusted return that predicts a range of annual returns of ~5-9% with an expected annual return of 7%? Or would you rather have 90% of your money in that portfolio with 10% spread out across 10 ‘risky’ investments that each have the opportunity to 100x? Let’s compare them over 10 years.
Portfolio 1: 1000 invested over 10 years
(1000)(1.05^10) = $1629
(1000)(1.07^10) = $1967
(1000)(1.09^10) = $2367
The result after 10 years is a range from $1629-$2367 with the expected amount being $1967.
Portfolio 2: 1000 invested over 10 years
If none of the risky investments pay off
(900)(1.05^10) + (100)(0) = $1466
(900)(1.07^10) + (100)(0) = $1770
(900)(1.09^10) + (100)(0) = $2130
If one of the risky investments pay off
(900)(1.05^10) + (100)(100) = $11466
(900)(1.07^10) + (100)(100) = $11770
(900)(1.09^10) + (100)(100) = $12130
The result after 10 years is a range from $1466 - $12130 with the expected amount being $1770
Would you accept a slightly lower expected return for the possibility of 10xing your investment?
How I apply this to portfolio construction
I’m a fan of Taleb’s Barbell Strategy. i.e. I split my portfolio into holding ultra conservative investments and ultra aggressive investments, assuming I’m bad at trying to quantify any risk in between. The ultra conservative investments ensure I’m not taking risks I cant recover from and the ultra aggressive investments assure I have positive optionality. As I’m generally young and can take a lot of risk with a long time to recover from it, I target 30-50% ultra conservative and 50-70% ultra aggressive.
On the ultra conservative investments I mostly just try to keep up with inflation, on the ultra aggressive side I’m trying to invest in things I think can be at least 5x.
I spend more time writing about my aggressive investments because they're more interesting, but on the conservative side here’s some of the things I’m investing in.
Gold
Gold Mining
Electric Utility Companies
Consumer staples
Grocery Stores
Bonds
Disclaimer: This does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this article should consult with his or her advisor.