“Risk—you must live with it, you can’t invest without it. Mike’s book does an excellent job explaining risk, and why we as investors (and real, live people!) need to understand this most basic element of our financial lives.”

—E. Blake Moore Jr. CEO, Allianz Global Investors Fund Management

“When investors are terrified, fight or flight—or freeze—are typical reactions, all of which destroy wealth! Mike Carpenter’s The Risk-Wise Investor offers a new and refreshing alternative, one investors (and their advisors!) can learn and profit from.”

—Charlotte B. Beyer Founder & CEO, Institute for Private Investors

“A valuable guide for navigating uncertain times that every investor should read and add to their investment library.”

—Peter Jones Franklin Templeton Investments

“When Michael Carpenter, a savvy, seasoned, and successful investment professional talks about risk, attention must be paid! This book is not a “how to” guide to becoming wealthy, but a rich compendium of tested strategies for protecting and growing your nest egg. Investors saving for retirement, for their children’s education, or for any long term goal will profit from it”

—Burton Greenwald BJ Greenwald Associates

“Financial risk has been a subject that is intimidating and not well understood, yet today has become the financial topic! Individual investors want financial risk to be defined, assessed, and managed. This book allows the investor to accomplish each of these and build a financial roadmap to calibrate their personal risk exposure.”

—Phillip D. Meserve Financial Strategist

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data:

Carpenter, Michael, 1947-

The risk-wise investor: how to better understand and manage risk/Michael Carpenter. p. cm.

Includes bibliographical references and index.

eISBN : 978-0-470-53094-8

1. Investments. 2. Risk management. 3. Investment analysis. I. Title.

HG4521.C2824 2009

332.6-dc22

2009013315

To Cindy
Wonderful wife, mother, and best friend
The smartest, sweetest, most patient
and understanding person I know

Preface

When you change the way you look at things, the things you look at change.

Max Plank
Nobel Laureate in Physics

Welcome and congratulations on your decision to read this book. Many people don’t realize that one of the most common characteristics of truly successful, long-term investors is their appreciation of the importance of investing their time, before they invest their money. Many of those investors learned the hard way the necessity of spending at least as much time understanding the risks of any potential investment, as well as the rewards, before investing their capital. They have found that the more they know about both the potential downside and the upside, the better decisions they make, and the more likely their investment decisions will pay substantial rewards.

User-Friendly Risk Management

Initially, risk management may appear to be a complex, highly technical, and daunting discipline. However, once you become familiar with the “Risk-Wise” approach you’ll see how user-friendly, nontechnical, and effective it can be. The fact that you are now investing your time to gain insights and improve your knowledge level of the enormously important subjects of uncertainty, risk, and risk management is a very positive step. Quite simply, not being aware of or ignoring the critical role risk management plays in successful investing is itself a primary investment risk. So you should congratulate yourself for identifying that overriding risk, acknowledging its importance, and investing your time in gaining a better understanding of risk and risk management. Those few steps alone set you apart from most investors and serve as a key predictor of your future long-term investment success.

The principal objective of this book is to help you become a true “Risk-Wise” Investor. It is focused on helping you to better identify risks, to reduce the likelihood and impact of risks that do occur, and to turn risks into inconveniences and even potential opportunities.

What Is a “Risk-Wise” Investor?

The term “Risk-Wise” Investor refers to any investors with the power of judging their risk/reward decisions correctly, and following the soundest course of action based on broad knowledge, understanding, experience, and preparation . Those simple, nontechnical attributes are the foundation of the entire “Risk-Wise” approach. They are the key to better understanding risk, and the risk management methodologies discussed in this book. They are also the very same factors that helped you learn how to become a master of risk management in dealing with the risks you face in your everyday life. In fact, it’s a fundamental truth of human existence that we are naturally fearful of what we aren’t familiar with or don’t understand. So the more you know and understand about anything, the less fear, better decisions, and fewer missteps you’ll experience, and the more successful you’ll be. That is especially true of risks. In the heat of our fast-paced modern lives, and our fascination and dependency on technology, we may have neglected to apply what has been known about effective risk management for centuries. Almost 150 years ago the great thinker and writer Ralph Waldo Emerson articulated a key foundation concept of effective risk management that is just as valuable today. He observed: “Knowledge is the antidote to fear.” Since fear is integral to our natural risk management system, that insightful observation reinforces the fact that improving our knowledge of risk is key to reducing our fear of risk and to opening the door to better risk management and becoming less anxious, more comfortable and confident investors. When increased knowledge of risk is paired with deeper understanding and thorough preparation, risks are managed much more effectively and our fears and anxieties are dramatically reduced. Simply stated, and with very few exceptions, what we know, understand, and are prepared for cannot harm us.

This important precept is extremely valuable to “Risk-Wise” Investors today. It serves as a guidepost in the continuous search for better ways to identify, understand, manage, and control risks. This strategy is also just as effective in addressing the newly evolving, and sometimes frightening risks emerging from our rapidly changing, faster-paced, more interconnected, and less certain world.

In reading this book you’ll become familiar with the basic practical knowledge, understanding, and preparation methods you’ll need to become a more effective “Risk-Wise” Investor, including:

• Using a new empowering definition of risk to improve your investment success.

• Finding a time-tested way to reduce unpleasant, negative surprises.

• Reducing the severity of negative surprises, should they ever occur.

• Converting risks into “inconveniences,” and even potential opportunities.

• Improving your investment success by understanding your risk biology.

• Seeing where and how to best focus your risk management resources.

• Learning how to know which risks should you avoid, accept, or manage.

• Creating a personalized, systematic process to better identify, manage, and neutralize the risks you face.

• Managing ongoing, ever-changing, and new risks.

• Better navigating extraordinary crisis events, bear markets, frightening volatility, and extremes of the business cycle.

Again, congratulations! Once you finish reading and absorbing the contents of this book, you’ll know and understand more about uncertainty, risk, practical risk management, and how to implement it for your personal benefit than the vast majority of investors. You’ll become a more “Risk-Wise” Investor. That knowledge and those insights will serve you well. They will help you better identify, understand, prepare for, and manage risk. You’ll enjoy the greater peace of mind that comes from truly understanding what you are doing and why you are doing it, plus you’ll avoid many of the potential pitfalls and investment nightmares that can occur along the way. Best of all you’ll improve the likelihood of reaching your personal financial objectives, regardless of the investment environment.

Acknowledgments

The fact that this book was conceived in the first place, let alone completed is due the ongoing encouragement, support, and help of numerous friends, neighbors, and associates all over the country.

Enormous thanks are due to great friends John Riordan, John Nicholson, Rahoul Banerjea, and John Paolucci, whose continuous encouragement, questions, and comments helped me so much when I first became interested in researching and developing a user-friendly, nontechnical approach to understanding and managing risk. A tremendous debt of gratitude is owed to my friends and authors Jim Huguet for his sage counsel and educating me on the many issues facing a potential author, and Beth Birkman for graciously familiarizing me with the book publishing process, and for saving me an enormous amount of time and trouble in researching all that she was happy to share with me over a cup of coffee. Special thanks to wordsmith, author, and now retired risk management professional and consultant, Felix Kloman, for sharing his life-long passion for studying, observing, speaking, and writing about the multidisciplinary and ever-fascinating subjects of risk and risk management. His generosity in providing some key information on the history of risk management made my job much easier. Deep appreciation is also extended to friends and portfolio managers, Tom Goggins and Bill Hamilton, who shared their invaluable perspective as very experienced investment and risk managers. Thanks also to Jack Kenney, for his inspiration, counsel, and fine example of investment professionalism; Janice Reals-Ellig, for her encouragement; Dawn Kahler, for providing the efficient frontier studies; Todd Hiller, for his always thoughtful perspective and comments; and Ed Boudreau, for his suggestions and observations on risk management, from a private pilot’s viewpoint. Special thanks to former submariner Dave Wilson, Fire Chief Ken Willett, and Deputy Police Chief Barry Neil, for their insights into the unique challenges and risk management methods used by professionals whose job is to deal with life-threatening risks on a daily basis.

The deepest gratitude to my parents, Tom and Betty Carpenter, for their encouragement to always follow my dreams, and my brothers, John and Jim, and sisters, Cindy and Kim, for their love and unwavering support. Many thanks are also due to Nannette, Dean, and Ashley Carpenter, and Elizabeth Brodsky, for their technical help and support; senior management consultant, Paula Camara, for her always thought provoking questions and enthusiastic encouragement; and the extremely knowledgeable, helpful, and always friendly staff at the Boston Public Library and the library’s Kirstein Business Branch.

My appreciation is immeasurable for Tom Thomas and Dick Forbes, the two investment industry veterans who many years ago gave me the opportunity to first enter their incredible business, actually train on Wall Street, and build a career as an investment professional. I must also thank all the investors, financial advisors, and former associates, team members, executives, portfolio managers and consulting clients I’ve been unbelievably privileged to work with and continued to learn from over the years. You have made me feel truly blessed.

Last but not least, special thanks to Senior Editor David Pugh, Development Editor Kelly O’Connor, Senior Production Editor Michael Lisk, and Editorial Assistant Adrianna Johnson of John Wiley & Sons for their responsiveness, ideas, editorial assistance, professionalism, and help in making this book a reality.

CHAPTER 1

The Increasing Importance of “Risk-Wise” Investing

May you live in interesting times.

Ancient Chinese Curse

Our world, investment markets, and investing itself have changed dramatically in just the last decade. Investing has been irreversibly altered by a number of powerful, interrelated factors including:

• Enormous growth in the volume, availability, and instant dissemination of investment information.

• Unprecedented expansion of the number and types of investment vehicles.

• A dramatic increase in the sheer number of investors, domestically and worldwide.

• An explosion in the total size of investment holdings.

• Huge increase in investors’ interest in, and knowledge of, investments and investing.

• The ongoing and remarkable lengthening of human life spans, raising the stakes and critical importance of investing successfully.

• The increased global interconnectedness of all investors, economies, markets, countries, and continents, and their growing interdependence on one another.

• The accelerating pace of worldwide change and all the uncertainties it generates.

• Enormously increased market volumes and at times gut-wrenching volatility.

These historic changes have created wonderful new investment opportunities and new challenges. They’ve increased the likelihood and impact of old familiar risks and totally new types of risks when the stakes for what’s at risk are now even bigger. With those dramatic and continuing changes, understanding and managing risk is more important than ever before.

The Holy Grail?

Based on what we see, hear, and read virtually every moment of every waking hour, each and every day, achieving outstanding investment performance is the Holy Grail of investing. It’s held up as the foundation of investment success. Enormous time, energy, and resources are devoted to identifying and urging us to take advantage of the newest, hottest investment ideas, best performers, and the next big investment winners all over the world.

For instance, the media overloads and overwhelms us 24/7 with analysts, pundits, seers, and prognosticators (often contradicting one another). They urgently forecast economic and market moves for the next year, quarter, month, week, hour, day, and unbelievably, even minutes, so that we can rush to take advantage of their insights. Simultaneously, we’re experiencing an enormous explosion in the number of new investment vehicles, trading tools, and information sources. We’re also seeing a deluge of new active and indexed investments strategies, all designed to “help us” make more money on both the positive and negative price movements of almost everything. We now live in an investment world offering more distinct types of investments to choose from, and more and different ways to make or lose money investing, than ever before in history. As more sophisticated active and index investment alternatives attract more assets and compete more intensively with one another, the range between strong and weak investment performance is also shrinking.

The same phenomenon is occurring with private equity, alternative investments, and hedge funds as well as many other investment types. As more managers with more assets under management chase similar opportunities, the range of performance narrows and gradually reverts to a tighter range, more closely grouped around the mean.

The Game Has Shifted

There is another change that’s occurred in the investment world over the last 20 years, which has been overlooked by many investors. The nature of this subtle, but very important change was first pointed out by renowned institutional investment consultant Charles Ellis in his thought-leading book, Winning the Losers Game.¹ In his book, Ellis reviews why and how investing has shifted from a “Winner’s Game” to a “Loser’s Game.” He describes how the nature of the investment world has changed to now favor those investors who make the fewest mistakes rather than the investors focused on gaining the highest returns. He observes that the key driver of investing success has become similar to the success drivers in activities like golf and amateur tennis. In all these pursuits the winners win not by outplaying their opponents but by making the fewest mistakes. If you have ever played golf or tennis, you are undoubtedly familiar with this phenomenon, because the harder you try to win, the more mistakes you tend to make.

Investing changed to a loser’s game when large numbers of very bright people, with lots of resources, access to timely information, and lots of money to invest began competing with one another to achieve the best performance. The advantage now goes to investors who understand the benefit (using a baseball analogy) of the more consistent winning strategy of hitting lots of singles and doubles, getting on base regularly, and avoiding errors and missteps rather than having everyone of the team swing for the fence, attempt to hit home runs, and then strike out.

Ellis strongly emphasizes that the primary objective of investment management is risk management. Managing risk has always been important, but now emphasizing risk management and “Risk-Wise” investing is the most important investment success factor in achieving your long-term investment goals. Of course, this concept isn’t new or just limited to investing. It is also the fundamental core of the Hippocratic oath made by physicians for thousand of years: “First, do no harm.” Even real estate mogul Donald Trump has stated, “Protect the downside and the upside takes care of itself.”

That viewpoint is now also shared by the world’s largest business enterprises. In fact, the advantages of proactive risk management have become so important that within the last 10 years more and more large companies have created and staffed a totally new C-Suite level function focused on risk management. Adding to the long established positions of CEO, COO, CFO, CIO, CMO is the totally new position, and firm-wide department of the Chief Risk Officer (CRO). The underlying question though, is why? Why have these very sophisticated global enterprises felt the need to create a new senior executive position to oversee risk and risk management?

These multinational firms are placing such a big emphasis on risk management because they see and understand its tremendous value and realize:

• In today’s world almost anything is possible (both positive and negative).

• Today’s stakes have never been higher, and risk management never more important.

• Offense wins games, and defense wins championships.

• If something can happen, it typically will happen (often at the worst possible time) unless action is taken on it in advance.

• It is critical to be ready and prepared for any contingency, no matter how extreme.

These huge enterprises understand how much more efficient and ultimately less costly it is to invest time and effort in being proactive, prepared, and ready for risks. It’s much preferable to paying the enormous tangible and intangible costs of being caught off guard, being unprepared for negative surprises, and furiously scrambling around to recover from risks when some of them inevitably become reality.

If major worldwide corporations, with all their resources and capabilities, are now focusing on risk and risk management throughout their entire enterprises, isn’t it even more important for individual investors to do the same? Individuals investing for their own and their family’s future carry the full responsibility of their future quality of life and prosperity, and it is all riding on their understanding and effective management of the investment risks they face. So where do you go to gain that critical understanding of such a multifaceted, multidisciplinary, and important a subject as managing uncertainty and risk?

The New Way to Gain Mastery

The big challenge for most investors in improving their knowledge of risk and risk management is that the subjects can seem complex, confusing, and even intimidating. When the unpredictability of the future is also factored in, the entire process can seem overwhelming and almost fruitless. As a result, many investors either give up on the effort right away or lose interest over time when confronted with the challenge. They just don’t have the extra time to dedicate to educating themselves on the complexities of the subject, with all the other demands on their attention. Even investors who are fully committed to improving their understanding of the subject are often disappointed, because most sources of information on risk management either oversimplify the subject or offer varying forms of technical overload. At one extreme are the sources that discuss the subject of risk and risk management simplistically and skim over it much too lightly. At the opposite extreme are sources that elaborate on highly technical, detailed, quantitative approaches (the details of Modern Portfolio Theory, the Efficient Frontier, quantitative analysis, variance, alpha, beta, and correlation coefficients, standard deviation) that don’t resonate even with many sophisticated investors, unless they also happen to be engineers, mathematicians, or statisticians.

The single most important thing to remember is that for any risk management approach to work, you must not only understand how the method works, but also why it works, so that you can understand its strengths and weaknesses. It also helps if, through personal experience, you know that it works under a full range of environments and circumstances. Next you must have enough knowledge of and confidence in the method to believe it will work, and then fully commit to it.

The most critical point to keep in mind is this: Any risk management system that any investor uses and does not understand, or does not have confidence in, will not work. The reason it won’t work is because investors who don’t truly understand and have confidence in their risk management methodology will many times abandon it, at the worst possible time. As a result, there is an enormous need for a user-friendly, knowledge-based, easy-to-understand, and easy-to-implement risk management approach. A new middle way is needed between the extremes of oversimplification and technical overload. That new knowledge-based, user-friendly alternative is the “Risk-Wise” Investor method.

The “Risk-Wise” Investor approach is specifically designed to help you and investors everywhere build a strong, knowledge-based understanding of risk and risk management in a practical, user-friendly, nontechnical, and easy to understand way. It is designed to increase your knowledge and understanding of risk management, and your confidence in your risk management abilities. It will also help its users make better informed investment decisions, reduce the number and impact of negative surprises, and improve the likelihood of investors achieving their long-term investment objectives. What makes the “Risk-wise” Investor approach so easy to understand and use is that you have and are already using it, very effectively, in numerous aspects of your daily life.

Release Your Own Natural, Everyday Risk Management Power

You are a very successful Master of Risk Management. Although you may be surprised by that statement, and may not actually feel like an expert risk manager, you indeed are one. In fact, you are an accomplished and very successful Master of Life-Risk Management if you are a normal adult human being. You are a Risk Management Master because you successfully deal with all kinds of risks (big, small, and some life threatening) multiple times, every single day. Your risk management skills are so well developed that many times you use them unconsciously. Just think about the life-threatening risks you take just driving to and from work or going out for simple errands, every single day.

You started learning about risks and risk management when you were very young. You survived all the risks of early childhood. You learned some of your risk management skills from your parents and siblings. They taught you about a full range of risks you faced and how to manage them. Unfortunately, some risks you had to learn about the hard way, and even today you may still carry the physical and mental scars from those painful lessons. If you have been or are now a parent, you know how often and how quickly small children can unknowingly place themselves in highly risky situations.

You’ve survived and learned to successfully manage the many dangerous risks of adolescence and the challenging teen years, when your emotions and raging hormones overruled your logic and controlled your actions. You may even remember some former personal friends from those days who weren’t as good at risk management or risk decision making as you and as a result didn’t survive their teens. In fact, teenagers are such a documented high-risk age group that auto insurance rates for teenagers and young adults are significantly higher than any other age group, except for those people well into their later senior citizen years.

When you graduated into adulthood you faced many new risks and learned how to manage them as well. The key point is that as adult human beings, we are all Masters of Life-Risk Management and very skilled in dealing with life risks. Not perfect by any means, because risk management is never perfect and accidents and mis-steps do happen. Even then, because we are prepared, we have mechanisms in place to minimize the impact of those surprises and almost inevitable accidents.

In general, adult human beings have extremely well developed risk management skills that are very easy to take for granted. Have you ever driven home, pulled in your driveway or garage and realized you don’t recall making any conscious decisions on your drive home? It’s as if you were on automatic pilot the entire trip. What’s really quite fascinating are the responses you get when you ask most people to describe what process they use so skillfully to manage the life risks they face every day. Most, even after thinking for a moment, can’t describe their risk management process because they don’t know it. They don’t think about it. They just do it. Those individuals have internalized their risk management process so much and become so comfortable with it that they can’t articulate what it is.

What would it be like if you could reconnect with the process you use so effectively to manage everyday risks and apply that same process and those same impressive risk management skills in the investment world? You would:

• Better understand and manage risk.

• Make better, more knowledge-based investment decisions.

• Have more confidence in your risk management skills.

• Make fewer investment mis-steps and experience fewer negative surprises.

• Reduce the impact of the unpleasant surprises that do occur.

• Improve the likelihood of achieving your long-term investment goals.

• Be a happier more successful, less anxious, ready for anything “Risk-Wise” Investor.

The core of the “Risk-Wise” Investor method, and what makes it so different, is how it refamiliarizes and reconnects you with the very same process you have used in learning and developing your own everyday, and natural, life-risk management skills. It then provides you with a nontechnical, and easy to implement, step-by-step process to use in creating your own personalized risk management plan, and ongoing risk managed decision-making process. Let’s now review the steps in our everyday, natural life-risk management process and see how easily they transition into the “Risk-Wise” Investor method discussed in the next chapter.

CHAPTER 2

Introduction to the “Risk-Wise” Risk Management Process

If a man empties his purse into his head, no one can take it away from him. An investment in knowledge always pays the best interest.

Ben Franklin

What would it be like if you could be as accomplished and comfortable managing investment risks as you are managing the risks you face in your every day life? You’d make fewer investment missteps, and reduce the severity of the risks that did occur. You’d also increase the likelihood of achieving your financial objectives, and you’d be a happier, less anxious, more confident, more successful investor.

That’s the objective of the “Risk-Wise” Investor risk management method. My purpose is to show you how to use this user-friendly, easy-to-implement way to release your innate, natural, and highly developed life-risk management skills in the world of investments.

As adult human beings, we are all very accomplished, and very successful managers of the many risks we encounter in our everyday lives. Yet as comfortable and accomplished as we are with managing these everyday risks, we often feel quite uncomfortable and ill-equipped to manage the challenging and sometimes very painful risks of investing. Many investors have become so frustrated by their inability to effectively manage investment risks that they’ve come to see the investment markets as giant casinos, and investing as a crap shoot or game of chance. Although that’s not the case, those feelings of exasperation, frustration, and second-guessing our investment decisions are only natural. They result from the growing uncertainties generated by our increasingly faster-paced, rapidly changing modern world.

Frequently those feelings are further amplified by surprise crises, economic shocks, natural disasters, and geopolitical or economic turmoil. The added concerns generated by gut-wrenching market drops, and increased market volatility, which defy even the forecasting skills of the most experienced investment experts, can intensify those feelings to the extreme.

So what is the process we use to so effectively manage our everyday life-risks? Why and how can those same skills work just as well in the investment world?

That’s exactly what we cover in the rest of this chapter. We start by refamiliarizing you with your own highly developed life-risk management process. Then we review how to use the elements of that ingrained system as the foundation of your own, user-friendly investment risk management method, and close by introducing you to the basic steps of the “Risk-Wise” Investor risk management process.

Releasing Your Natural, Everyday Risk Management Skills

The more you become familiar with and use the “Risk-Wise” Investor risk management approach, the better you’ll understand and more effectively manage the risks you face now and in the future.

First, you need to refamiliarize yourself with the natural, step-by-step process you used in gaining your skill and comfort in managing everyday life-risk. However, that can be challenge for anyone; since by the time we reach adulthood the vast majority of us have internalized our risk management process so much that it has become automatic. We’ve become so comfortable managing life-risks; we do it on an instinctive level without even thinking about how we do it. In fact, when asked what process they use in managing their everyday life-risks, many people say that they don’t have a specific process. They just do it.

As such, I encourage you to take a moment right now to think through the steps you personally use in successfully managing the life-risks you face everyday. Then write those steps down. (Give yourself a little time to think about it and let it resurface, then write each step down in the spaces provided.)

Now, did the steps in your own risk management process come to mind easily, or did they require serious effort to recall? How successful were you in listing all the steps? How long did it take? If you are like most people, you found it surprisingly difficult for a process that you use so many times each and every day.

Although our bodies are hard-wired with many built-in, involuntary life-risk management systems (like our natural reaction to blink when something moves rapidly in front of our eyes or our instantaneous reflex reaction when we touch something hot), most of our life-risk management skills are learned skills. We learn them from our parents, friends, by watching others, and by ourselves.

Below is a quick review of the step-by-step process we humans use in learning how to so effectively manage the life-risks we face.

The Everyday Life-Risk Risk Management Process Steps

1. Identify Risks. Determine, and remember for future use those things that may cause harm or interfere with your physical health, goals, or objectives.

2. Understand Risks. Learn as much as you can about each potential risk, including its likelihood of occurring and its impact should it occur.

3. Review Risk Reduction/Risk Management Strategies Available. Become familiar with any and all strategies that can be used to avoid each risk, reduce the likelihood of a risk occurring, and minimize a risk’s impact should it still occur.

4. Evaluate the Risk/Reward Tradeoff (with and without risk management). Review the rewards of an action, or inaction, and the risk reduction options available to use versus the risks (likelihood and impact) of the potential action or inaction.

5. Make Your Decision to Act or Not Act. Once you identify and understand the rewards and the risks (likelihood and impact), have evaluated the effectiveness of the risk management strategies available to use, and have a full understanding of your risk/reward trade-offs, you then make your decision to either act or not act. You can then decide to avoid the risk entirely, act and accept the risk with risk reduction initiative(s) in place (reducing the risk likelihood and/or impact) or act and accept the risk with no risk reduction.

6. Implement your decision.

7. Learn and Adapt. Continuously learn from actual experience, then use what you learn to make better risk/reward decisions in the future.

Although these steps may at first seem simplistic, their ultimate risk management success is the result of each step building sequentially on the foundation of the one before to create a very powerful and effective risk management system.

Releasing Your Everyday Life-Risk Management Skills in the Investment World

As a result of its effectiveness and flexibility, you can apply that same basic, step-by-step, life-risk management process to managing investment risks, while paying special attention to some of the differences in managing investment risks versus real world, life-risks (Which we’ll cover in-depth soon.)

In addition, it’s very important to be patient with yourself. You gained your facility with managing life-risks over at least several decades. So remember, just like learning to do anything new, managing investment risks may initially feel a little awkward, cumbersome, and slow. However, the more you use it and repeat it, the faster, easier and more comfortable you’ll become. Then, over time, it becomes so automatic, internalized, and second nature, that you won’t even have to even think about it any more. You’ll just do it.

The Fundament Principals of “Risk-Wise”Investing

Before reviewing the “Risk-Wise” Investor risk management process it is very important to consider some basic facts about risk and its management. First, life, risk, and reward are inseparable, interconnected elements. In fact, just to live at all exposes each of us to numerous risks, not the least of which is day-to-day survival.

In discussing risk management, Walter Wriston, Former Chairman of Citicorp, Chairman of the Economic Policy Advisory Board for President Reagan from 1982 to 1989 and recipient of the Presidential Medal of Freedom said at www.online.citibank.co.in/portal/co/var.ppt: “All of life is the management of risk, not its elimination.”

This means that since it’s impossible to eliminate risk in life, we are all exposed to numerous kinds of risk whether we like it or not. As a result, since we can’t eliminate risk, we each must decide to either manage risks or be subject to their raw and potentially painful impact. Below are a few basic principals of risk management that are very important to keep in mind as you go about managing risk.

• Risk and reward are a normal part of life, of everything we do, including investing.

• Risk/reward trade-offs are integral to every decision, action, or inaction.

• Effective risk management is critical to long-term investment and life success.

• Risks can be managed, but never eliminated.

• You cannot effectively manage risk or uncertainty without understanding it.

• The more you know about risk and risk management the more effective you’ll be.

• Risk management will not work effectively if you do not understand how and why it works or have confidence in it.

• The most effective method of managing risks is to:
• Directly face risks.
• Become familiar with risks.
• Understand risks.
• Prepare for risks in advance.

When investing, the practical implementation of these risk management principles can best be achieved by using the same logical sequence of steps all of us use in our everyday life-risk management processes. The “Risk-Wise” Investor risk management method follows those steps, and in addition integrates into each step the special, unique considerations necessary for successful “Risk-Wise” Investing.

Building a Solid Foundation

Although the following process may at first glimpse appear simple and straightforward, don’t allow its simplicity to deceive you into underestimating its value and power.

Just because something is complex or quantitatively based, doesn’t mean it is necessarily better or more effective. Keep in mind what Benoit Mandelbrot, distinguished Sterling Professor of Mathematical Science at Yale University, one of the fathers of chaos theory, the inventor of the new field of fractal geometry (the geometry of nature), and extensive researcher of market price changes said in his excellent 2004 book The (Mis)Behavior of Markets. In discussing the efficient market hypothesis, which has been embraced by Wall Street, and become so popular with many academics, consultants, market analysts, and portfolio managers over the past 30 years, Professor Mandelbrot says, “Alas, the theory is elegant but flawed, as anyone who has lived through the booms and busts of the last decade can see.”¹

As with any successful multistep process, each step of the “Risk-Wise” process is built on the previous one. The quality and effectiveness of your end results, and the risk management benefits you enjoy will depend entirely on how well and how thoroughly you complete each preceding step. With each step in this risk management process being the foundation of the next step, the book devotes considerable additional time to familiarizing you with key information, valuable insights, and important facts you’ll find essential in effectively building a solid foundation at each step of the “Risk-Wise” risk management process.

The “Risk-Wise” Investor—Risk Management Process Steps

Now that you’ve refamiliarized yourself with the steps in your own, everyday, life-risk management system, and reviewed the fundamental principles of effective risk management, it is time to introduce you to how to apply those insights in managing the risks in the investment world. Once you become familiar with the “Risk-Wise” Investor approach and begin using it more and more, you’ll gradually find yourself becoming as accomplished at managing investment risks as you are managing the everyday life-risks you face.

The “Risk-Wise” Investor Process

1. Personal Risk Assessment
• Define risk (your definition of risk is the foundation of the entire process).
• Identify risks (you can’t manage a risk you haven’t identified as a risk).
• Understand risks (their likelihood and their personal impact should they occur).
• Determine which risks to avoid, accept, and/or manage.

2. Review risk reduction/management strategies available (their strengths and weaknesses).

3. Evaluate your risk/reward trade-offs (while avoiding common evaluation pitfalls).

4. Make your decision to act or not act—then implement it (while avoiding the common decision-making traps of many investors).

5. Effective ongoing risk monitoring and decision making (continuously being on guard for the emergence of new risks or threats and the evolving nature of known risks).

Building on this basic outline of the “Risk-Wise” Investor risk management process, the rest of this book will focus on how you can put each step of that process into action with extensive practical insights and valuable additional information that will help you build you own personal, customized risk management plan. We’ll review how to apply a new empowering definition of “risk” used by some of the top corporate chief risk officers (CROs) to your lifetime risk management and investment success. We’ll also discuss insights and lessons from the new field of behavioral finance and how to use them in avoiding very common risk/reward decision-making traps. In addition, we’ll cover a simple way to determine which risks you personally should avoid entirely, which risks to take and manage, and which ones to just accept.

On completing this book you’ll have also learned how to manage the full range of risks occurring in roaring bull markets; frightening bear markets; uncertain markets; and sometime the most challenging risks of all, the risks, traps, and pitfalls of our own, frequently flawed, decision-making biases. You’ll have everything you need to create and implement your very own customized, comprehensive, ready-for-anything investment risk management plan, and will be well on your way to becoming as accomplished and comfortable in managing investment risks as you are in managing your everyday life-risks.

CHAPTER 3

The Evolving History of Risk and Risk Management

Better to be wise by the misfortune of others than by your own.

Aesop

Of course risk and risk management are nothing new to human experience. They are as much a part of being human as living and breathing. Yet most of us know very little about how risk management has developed and evolved over time. So the very first step in improving our own knowledge and understanding of risk and risk management must be to become familiar with the history of this very important subject. Only then can we benefit from that knowledge in managing the risks we ourselves face today.

Rather than review the history of risk and risk management in detail, we’ll be taking a multidisciplinary, highlights approach. However, it can still benefit you greatly to study this very important subject in further detail. Therefore, I strongly recommend you read works such as Charles Kindleberger’s classic book on the history of financial crises, Manias, Panics, and Crashes, Peter Bernstein’s excellent history of risk, Against the Gods, and the classic, Extraordinary Popular Delusions and the Madness of Crowds, by Charles Mackay, and any of the many other fine books on the history of money, investing, and risk. You’ll be very glad you did.

Historical Highlights

In reviewing this chronology, you’ll also see just how our world is becoming both safer and riskier at the same time. This seeming paradox occurs because as we live with established and familiar risks we gain control and mastery over them, and gradually we become less concerned about them. However, the accelerating pace of change and the ever-more-interconnected nature of our modern world means that new, unfamiliar, and often frightening risks we’ve never experienced before can pop onto the scene to challenge our risk management abilities. Simultaneously, we can also very easily fall victim to overconfidence in our risk management abilities, let down our guard, and end up paying a very high price for erroneously assuming that some of our old, familiar risks were fully under our control.

This overview of the history of risk and risk management addresses the gradual evolution of our risk management knowledge and skills over time. It highlights examples of our triumphs over some risks, as well as instances where risks have surprised us, harmed us, and taught us how to better deal with them in the future. This review is divided into three general sections, each coinciding with the three main eras in the evolution of our growth in understanding risk, risk management, and uncertainty:

Part 1: A brief review of the ancient world through the Middle Ages.

Part 2: The pivotal role of the Renaissance

Part 3: The post-Renaissance period to the present.

This review is not meant to be a comprehensive study of the history of risk management but rather a quick, high-level overview of the growth of our knowledge of risk and risk management over time, better understanding, and a deeper knowledge of how we humans are gaining a better understanding of risk and how to manage it more effectively.¹

Part 1: The Ancient Past (Pre-600 B.C.)

The fragile, and challenging nature of the hunter/gatherer lifestyle of very ancient times placed enormous demands on the ability of people to survive from day to day. Often referred to as the Ancient Past, this period lasted until about 600 B.C. in most parts of the world. Listed below are a few insights into what life was like for humans during that ancient period of time.

• People lived at the mercy of their environment and were consumed with the basic, continuous struggles of finding enough food, providing shelter for themselves and raising their offspring.

• The seasons, weather, and the availability of food dictated peoples’ lives.

• Human life spans were considerably shorter than they are today.

• One day was very similar to the next, with little change over time.

• Decisions were driven by instinct or the necessity to follow food sources.

• Men and women were truly passive before nature.

• Oracles, witchdoctors, astrologers, and soothsayers read the stars, entrails, smoke, dreams, and animal bones in an effort to help people gain insights into their uncertain future, and/or what the gods had in store for them.

• During this period people viewed their future as a matter of random chance, luck, and/or the vagaries of the forces of nature or the gods. Humans took what was dished out to them and did the best they could to deal with the conditions that were presented.

• People invented unseen forces and ascribed divine intelligence to natural phenomenon, which they then could blame for misfortunes, praise and thank for good luck, or sacrifice to in order to gain indulgences, favors and special requests.

• Gradually, people began to see natural patterns and began to use that knowledge to their benefit. They developed mechanisms and systems to deal with what they could expect as well as the occasional surprises that could occur, even if they couldn’t predict the exact timing or form of those surprises.

• People were unable to conceive of having any real influence or control over the circumstances of their lives.

Over thousands of years, farming, and then the domestication of livestock gradually developed. Those innovations led to the establishment of permanent villages, then towns, cities, states, and eventually empires. Even when towns and cities developed, people still had little or no control over their lives. Their futures were set out for them from birth. They were born into the vocation of their families, and even those individuals of noble birth had no real alternative but to live the life they were born into, in their particular locale. In fact, traveling outside their immediate home base was rarely done because of travel’s many dangers, perils, and uncertainties. People literally had little or nothing to say about their futures. Life was simple, hard, generally very short by today’s standards, and offered people few options and few opportunities to influence their fate.

Early History (600 B.C.-A.D. 500)

By 600 B.C. cities, kingdoms, and civilizations had developed. Many of the modern characteristics of civilized societies we know today were already in place and reasonably well developed. Yet humans still possessed very limited ability to control their lives or determine their own futures because so much of what happened to them was beyond their personal control.

In fact, generation after generation of Chinese, rather than use their own judgment, depended on the teaching and guidance offered in the I Ching. During their classic era even the Greeks, as culturally sophisticated as they were, still consulted the Oracle at Delphi for insights into the future on their most important issues. Here are some other insights into life during this period of early human history.

Sixth Century B.C.: The Chinese sages Confucius and Lao-tzu developed and taught their principles. Confucius emphasized self-cultivation and a preference for sound judgment, equilibrium and harmony, while Lao-tzu, the father of Taoism, was greatly influenced by nature and taught the benefit of letting events follow their natural course. This period also saw the beginnings of Greek philosophy.

Fourth Century B.C: Plato asserted that all things partake of two worlds: the visible world that is always changing and the intelligible world that remains unchanged

333 B.C: Alexander the Great expands the limits of what was ever thought possible, from the scope of his conquests, to demonstrating how effective out-of-the-box thinking can be in solving problems, when cleaving the Gordian knot with his sword.

49 B.C: Establishing a historic example of unalterable decision making, Julius Caesar crosses from Gaul into Italy over a stream called the Rubicon, breaking a Roman law forbidding any general to lead his troops onto Italian soil.

The Middle Ages (A.D. 500-A.D. 1500)

The Middle Ages lasted about a thousand years from the fall of the Western Roman Empire in the fifth century to the beginning of the Early Modern Period. The Reformation of Western Christianity, the growing view of the “dignity of man” in the Italian renaissance, and the beginning of European overseas expansion signaled its end.

This was truly a multiphased transition period lasting almost one thousand years. The following timeline briefly highlights some of the important characteristics of life during each of the major phases of the middle ages.

The Dark Ages (500-800) directly following the fall of the Romans was characterized by:
• Elevated political uncertainties (in the vacuum left by Rome’s fall).
• A reduction in economic activity.
• Successful incursions into Europe by non-Christian peoples.
• The general loss of learning and literacy.
• The church and clergy were the unifying cultural influence, which also maintained the arts and knowledge of writing and reading.

The High and Later Middle Ages (800-1400): were characterized by:
• A revival of urban and commercial life.
• The development of the institutions of lordship and vassalage.
• Castle and cathedral building.
• Mounted warfare and the Crusades.
• Growth of royal power.
• The rise of commercial interests.
• The great plague of the fourteenth century.

800-900: The Arabic number system (originally developed by the Hindus), which includes the new invention zero, becomes accepted throughout the Arab empire, and energizes the use of mathematics due to its ease of use compared to previous systems.

1066: The Norman conquest of England and the age of feudalism.

Eleventh Century 1100-1200: The foundations on which algebra is developed are articulated by the Persian poet, polymath, philosopher, teacher, and mathematician Omar Khayyam
• The precursors of Universities like Oxford and Cambridge were first established as scholastic enclaves by religious monks
• Literacy started becoming more available to a wider class of people.

1215: The Magna Carta becomes the basis of constitutional government.

1291: Two hundred years of Crusading ends with the fall of Acre. While tens of thousands died in them, the Crusades led to Europeans being introduced to many new technologies, developed trade routes, and improvements in navigation. Silk, which was known to the Romans much earlier and new items such as gunpowder and navigational aids were discovered by the West, which made the great Age of Exploration possible.

Twelfth and Thirteenth Centuries: A dramatic increase in the rate of new inventions and innovations began taking place. These included invention of the cannon, spectacles, and cross-cultural introduction of the compass and astrolabe.

• Improvements were made to the design and construction of ships, improving seafaring.
• Great numbers of translations of Greek and Arabic medical and scientific works were distributed throughout Europe.
• Aristotle and his rational, logical approach became very important.

Part 2: The Renaissance

The major transition period between modern times and the past was the Renaissance. It began in the 1300s in Italy, spread to the rest of Europe in the 1400s and 1500s, and generated revolutions in art, science, culture, religion, and thinking. Listed below are a few high points of the period.

• Beliefs of more than 3000 years were openly challenged and left behind.

• Humans began to believe they could actually understand and gain control over their world and manage the risks they faced.

• Artistic expression blossomed.

• Scientific inquiry, knowledge, and interest exploded.

• Printing press is invented.

• New world is discovered.

• The incredible Age of Exploration begins.

• Commerce and trade blossomed.

• People could now earn wealth and were not limited to inheriting it.

• Superstition and tradition lost their strangleholds over people’s thinking.

• Serious study of risk and risk management began.

• A fourteenth-century English friar proposed Occam’s Razor, a rule of thumb for scientists and other trying to analyze data: The best theory is the simplest one that accounts for all the evidence.

Part 3: Entry into the Modern Age and Up to the Present

The late renaissance in the 1600s marks the beginning of the western world’s transition into the modern age. From this period onward, the pace of humankind’s growth in knowledge, progress and change has continued to accelerate up through the present day. The growth in our knowledge, understanding and management of risk is no exception. The following timeline reviews developments and events of note in that continuously evolving process. As you review this segment of the timeline, don’t focus so much on the details of each event; concentrate on the flow of events, the increasing pace of change, and the escalating importance of proactive risk management.

1620: Francis Bacon, English philosopher, lawyer and politician promoted the advantages of scientific study over inductive reasoning.

1630s: The Dutch issued and traded options securities virtually identical to those we use today.

1641: René Descartes, French philosopher, mathematician, and scientist proposed reason as a better way of gaining knowledge and established the foundation of the scientific method we still use today. He popularized the fundamental precept of sound reasoning, that anything must be doubted until it can be demonstrated or proved.

1650s:
• Printing and books had ceased to be a novelty.
• The Amsterdam stock exchange was flourishing.
• Blaise Pascal and Pierre de Fermat developed the basic concept of calculating probabilities for chance events from gambling.

1660: Pascal’s wager on the existence of God showed that the consequences of being wrong can be the most important factor to consider for a decision maker, rather than the likelihood.

1687: Edward Lloyd founds Lloyd’s of London in his coffee house. He creates a risk marketplace where first ship owners, and then others seeking insurance against financial risk, could acquire that protection from a risk taker (underwriter) for a mutually agreed premium payment by the insured.

1693: Edmund Halley, The astronomer famous for Halley’s comet, developed the first mortality (life expectancy) tables.

1703: Gottfried von Leibniz’s comment, “Nature has established patterns originating in the return of events, but only for the most part,” to math genius Jacob Bernoulli prompts Bernoulli to invent the Law of Large Numbers and statistical sampling. Bernoulli’s work then leads to the modern activities of statistical polling, wine tasting, stock picking, and the testing of new drugs.

1720: The “Bubble Year.” The South Seas Bubble in England, the Mississippi Bubble in France, and a remarkable range of other new investment ventures, many financed with borrowed money, all creating enormous speculative frenzy throughout England and Europe, finally collapsed. They financially devastated large numbers of individuals and institutions alike.

1730: Abraham de Moivre first demonstrated the structure of normal distribution of random events, introducing what we know today as the bell curve.

1738: Daniel Bernoulli created the basics of risk analysis by observing random events from the personal standpoint of how much an individual desires or fears each possible outcome, and he introduced the term utility to risk management. He stated that the desire of any individual for more over less is inversely proportional to the quantity of goods the individual already possesses.

1763: Housing, turnpike, and canal speculation throughout Europe.

1774: Dutch merchant Adriann van Ketwich creates the first investment fund, which he named Eendragt Maakt Magt or “unity creates strength,” on the principle that diversification and its resulting reduction of risk would appeal to smaller investors.

1793: English canal mania hits (bubble).

1797: Collapse of the French Assignat currency from hyperinflation.

1822: King Wilhelm I of the Netherlands launches the first closed-end mutual fund.

1825: Latin American bonds, mines, and cotton mania.

1847: Railway and wheat speculative excesses in England.

1848: Carl Frederick Gauss studied the blell curve, earlier described by de Moivre, and developed a structure for understanding random events that are large in number and independent of one another.

• Continued railway and public land speculation.
• California Gold Rush began with discovery of gold at Sutter’s Mill.
1873: Railroad, homesteading, and Chicago building booms in the United States.

1875: Francis Galton (the first cousin of Charles Darwin) discovered the concept of regression to the mean. That concept is based on his observation that although values in a random process can differ from the average value, in time they will move back to it. This concept will influence a number of areas, including investing, and can be recognized in everyday observations such as:
• Why Pride goes before a fall and clouds tend to have silver linings.
• Why we make decisions based on extremes returning to normal.

1890: Silver and gold speculation leading to inflation (Sherman Silver Act in the U.S.).

1893: The Panic of 1893 and repeal of the U.S. Sherman Silver Act, which reversed previous excesses.

1900: Sigmund Freud’s analysis of the unconscious mind found that people’s decisions and actions can frequently be effected by factors concealed in the mind rather than by pure logic.

• The great Galveston, Texas, hurricane and tidal surge killed more than 5,000 people and destroyed the city in less than 12 hours, leading to dramatic changes in the scope and nature of weather prediction in North America and the world.
1906: 5:12 A.M., April 18, the Great San Francisco Earthquake began its 45-60 seconds of shaking, massive destruction, and raging fires. It led to over 2000 deaths, the demolition of the largest city in the western United States, and key lessons on the importance of managing the secondary and tertiary earthquake risks of weak building design and construction methods and poor fire preparedness.

1907: Coffee and rubber booms in Brazil and the United States. The Union Pacific Railroad boom.

• The Panic of 1907 A number of Wall Street brokerage firms went bankrupt, The Knickerbocker Trust and Westinghouse Electric failed, the Dow-Jones Industrial Average dropped 45 percent from its previous high, and J.P. Morgan brought together leading financiers to save the banking system and the economy.
• Irving Fisher, an American economist developed the concept of net present value as a tool to help make better decisions. He proposed discounting expected future cash flow at a rate that considers an investment’s risk.
1913: The U. S. Federal Reserve Bank was created to actively manage the very common boom and bust swings of the U.S economy and to act as lender of last resort to the banking system, should the need arise again.

1921: Frank Knight published Risk, Uncertainty, and Profit. The book became a keystone in the library of risk management. He distinguished uncertainty, which is not measurable, from risk, which is. He celebrated the prevalence of “surprise” and cautioned against over-reliance on extrapolating past frequencies/probabilities into the future.

• A Treatise on Probability by John Maynard Keynes appeared. He derided dependence on the Law of Large Numbers, emphasizing the importance of relative perception and judgment.
1923: The Germany Weimer Republic experienced hyperinflation, with prices for everything doubling every two days at its peak. Banknotes had lost so much value they were used as wallpaper.

1924: The first modern mutual fund (open-end investment company) was started in Boston by MFS Investment Management. Later the same year, State Street Investors Trust launched the second mutual fund.

1926: John von Neumann presented his first paper on a theory of games and strategy at the University of Gottingen, suggesting he goal of not losing is superior to that of winning.

1928: The first antibiotic drug, Penicillin, was accidentally discovered by Dr. Alexander Fleming, beginning the antibiotic revolution in medicine, reducing the risk of lethal infections and saving tens of millions of lives worldwide ever since. Example of logical risk management; First method to effectively reduce the common risk of death from infection.

• The first no-sales charge mutual fund was launched by the investment firm of Scudder Stevens and Clark of Boston.
• The first mutual fund to include both stocks and bonds, The Wellington Fund, was launched.
1929: There were 19 open-end mutual funds competing with 700 closed-end funds.

• In late October the stock market bubble, which had been building for over 10 years burst, dropping from a DJIA high of 381.17 on September 3 to a low of 41.22 on July 8, 1932. That drop created a total loss of 89.19 percent over that three-year period. It took until 1954, almost 22 years, to once again reach its previous 1929 high.
• With the stock market crash, the highly leveraged closed-end of the time were wiped out although smaller open-end funds managed to survive.
1933-1934: The Great Depression in the United States reached its deepest point.

• The U.S. Securities and Exchange Commission was created to regulate the securities markets (and improve risk management).
• The Securities Acts of 1933 and 1934 were enacted to safeguard and protect the interests of investors, and mutual funds were required to register with the SEC and provide disclosure in the form of a prospectus.
1944: John Von Neumann (also see 1926) and Oskar Morgenstern published their paper, “The Theory of Games and Economic Behavior,” which describes a mathematical basis for making economic decisions. They embraced the view that decision makers are always rational and consistent, in general agreement with most economic thinkers before them.

1945: The Atomic Age began; and the enormous rewards, risks, responsibilities, and related risk management issues raised deep concerns for all humankind.

• The Nuclear Arms Race initiated between the United States and the U.S.S.R.
1946: The Magic 8 Ball decision-making aid was invented by The Alabe Crafts Company of Cincinnati, Ohio. It was designed to help people make decisions under uncertain conditions.

1947: Rejecting the classical notion that decision makers behave with perfect rationality, Herbert Simon argued that because of the costs of acquiring information, executives make decisions with only “bounded rationality,” and make do with good enough decisions.

1952: Dr. Jonas Salk began human testing of his new (killed virus) polio vaccine, designed to neutralize the risk of polio, which at the time was everyone’s second-greatest fear after the fear of nuclear attack. Dr. Salk’s vaccine was finally declared safe and effective in April 1955. His vaccine, over time, virtually eliminated the risk of Polio, saved million of lives and untold suffering around the world.

• The Journal of Finance published “Portfolio Selection,” by graduate student Harry Markowitz, who later won the Noble Prize in 1990. It explained aspects of return and variance in an investment portfolio and why diversification works, leading to many of the sophisticated quantitative measures of financial risk in use today.
1956: The Harvard Business Review published Risk Management: A New Phase of Cost Control, by Russell Gallagher, then insurance manager of Philco Corporation. It highlighted the cost savings of risk management.

1960s: Edmund Learned, C. Rowland Christiansen, Kenneth Andrews, and others created the SWOT (strength, weaknesses, opportunities, and threats) model of analysis, and it became widely adopted as a practical decision-making aid.

1961: The term “Catch-22,” from Joseph Heller’s best-selling book, became popular for describing bureaucratic, frustrating, and illogical procedures that impede good decision making and risk management.

1962: Dr. Albert Sabin saw his oral polio vaccine (live-attenuated virus) approved by the FDA. Along with the Salk vaccine, it further contributed to the virtual elimination of the risk of polio throughout the world, within 40 years.

• Silent Spring by Rachel Carlson was published, challenging the public to seriously consider the risks of the degradation of our air, water, and ground from both inadvertent and deliberate pollution. This led to the creation of the U.S. Environmental Protection Agency in 1970 and the global Green movement so active today.
1964: Bill Sharpe articulated his Capital Asset Pricing Model in the Journal of Finance. He also developed what becomes known as the Sharpe Ratio, and eventually is extensively used to characterize how well the return of an asset compensates the investor for the risk taken. (Sharpe subsequently received the 1990 Nobel Prize in Economics along with Harry Markowitz.)

1965: The rear engine, compact car, the Corvair, manufactured by Chevrolet was exposed. Ralph Nader’s book Unsafe at Any Speed appeared and gave birth to the consumer movement in the United States, then throughout the world.

1966: “Nuclear option” became a widely used new term (based on the massive impact of atomic weapons) used to indicate the most extreme option when making a decision.

• The insurance Institute of America developed a set of three examinations that led to the designation Associate of Risk Management, the first such certification.
1968: Decision Analysis, a book by Howard Raiffa, reviewed many decision-making techniques, including the use of decision trees and sampling to aid in decision making.

1969: In a triumph of stunningly successful risk management, focused effort, and technical achievement, in just about eight years President Kennedy’s 1961 challenge to “land a man on the moon and return him safely to the earth by the end of the decade” was spectacularly achieved.

1972: Dr. Kenneth Arrow and Sir John Hicks won the Nobel Prize in Economics. Arrow imagined a perfect world where every uncertainty was identified, the Law of Large Numbers worked without fail, then pointed out that our knowledge will always be incomplete and “comes trailing clouds of vagueness.”

1973: Fischer Black and Myron Scholes in a breakthrough academic paper, showed for the first time how stock options can be accurately valued. Their work began a transformation in the field of investment risk management. It took until the 1987 stock market crash and then again in the 1998 financial crisis (which was punctuated by the collapse of the hedge fund Long-Term Capital Management, where Black and Scholes were partners) for the flaws in their theoretical model to be exposed by actual financial panics.

• The OPEC oil embargo skyrocketed oil and gas prices, fuel rationing, high inflation, and extremely high interest rates.
1974-1975: Crash in the price of stocks, REITs, office buildings, and 747 jetliners. (The Dow Jones Industrial Average dropped to 577.)

1976: Fortune Magazine, with the support of the Risk and Insurance Management Society published a special article entitled “The Risk Management Revolution” articulating many ideas, which took over 20 years to be adopted.

• Hayne Leland and Mark Rubinstein, fellow finance professors at U.C. Berkeley developed the revolutionary idea for a new investment concept called Portfolio Insurance, which was designed to provide the upside potential in stocks with the downside limited only to an insurance premium (see the notes under 1987 to learn how well this innovation worked).
1979: Amos Tversky and Daniel Kahneman published their Prospect Theory, which established Behavioral Finance as a new academic discipline. They showed how the traditional rational model of economics incorrectly describes how people arrive at decisions when facing real-world uncertainties.

• The cover story “The Death of Equities” in Business Week magazine’s August 13 issue became a famous example of a contrary indicator, since within a few years the stock market began a 20-year bull run, increasing over 1000 percent by the end of 1999.
1980: The Society of Risk Analysis formed in Washington, D.C., to represent public policy, academic, and environmental risk management advocates.

• Through the SRA’s efforts the terms risk assessment and risk management became more familiar in North America and Europe.
• Monte Carlo simulations became popular in the theories of random walk, asset pricing, and finance, as a way of exploring a range of possibilities.
1983: William Ruckelshaus, the former director of the Environmental Protection Agency, delivered his speech on “Science, Risk, and Public Policy” to the National Academy of Sciences, launching the risk management idea in public policy.

• Risk management reached the national political agenda.
1984: The horror in Bhopal— 40 tons of poisonous methyl isocyanate gas were accidentally released from a Union Carbide chemical plant in Bhopal, India, killing 3,800 people and injuring 11,000 people. The accident served as a bellwether to the entire chemical industry and a catalyst for increased focus on risk management and safety reforms.

1986: Meltdown at Chernobyl: The Soviet nuclear power plant experienced a core reactor explosion as the result of a planned experiment that went bad. It sent a huge radioactive cloud into the atmosphere, immediately killing 31 people from radiation poisoning, forcing the evacuation of 130,000 people, and spreading radiation over most of Europe.

• Space Shuttle Challenger exploded just after liftoff on January 28, killing all crewmembers on board, setting the shuttle program back over two years, and becoming a horrific example of how even small errors in managing risk in complex systems can have catastrophic consequences.
• The Institute of Risk Management began in London establishing the first continuing education program in all facets of risk management.
1987: “Black Monday,” October 19, 1987, hit the U.S. stock market. Its global shock waves reminded all investors of the risk and volatility in the markets.

• The Dow Jones Industrial Average (DJIA) dropped 508 points, to 1739 on record volume. The 22.5 percent one-day DJIA drop was the largest one-day percentage decline in stock market history and also set off record declines in stock markets around the world.
• The flaws of portfolio insurance, invented in 1976 (based on the quantitative Black/Scholes options pricing model) and then broadly used by institutional investors to reduce risk were widely exposed by the market crash. The inability to implement its strategies in a market route and the cost of portfolio insurance turned out to be much higher than the paper calculations had predicted, which invalidated the model. With the concept failing to prevent large losses, it totally fell out of favor and has not been used the same way since. As Michael Lewis said in the introduction of his book, Panic, The Story of Modern Financial Insanity, copyright 2009, and published by W.W. Norton & Company, “The very theory underlying all insurance against financial panic fell apart in the face of an actual panic.”
• Important assumptions concerning human rationality, the efficient market hypothesis, and economic equilibrium were brought into question by the event.
• Debate as to the cause of the crash of 1987 still continues many years after the event, with no firm conclusions reached.
1989: The Exxon Valdez super tanker ran aground on a reef in Alaska’s Prince William Sound and punctured eight of its cargo holds, spilling over 11 million barrels of crude oil into one of the world’s most pristine natural areas. The severity of the spill and the ineffective response to it created an economic and environmental disaster, leading to subsequent improvements in the design and construction of oil tankers and oil spill response preparation around the world.

• United Airlines Flight 232, while flying en route to Denver from Chicago, experienced an engine explosion, which expelled debris that severed all three hydraulic systems on the aircraft, leaving the pilot without any control of his DC-10. Through very unconventional methods, courageous effort, skill of the cockpit crew, and a highly coordinated emergency response, the plane was able to make a crash landing at the Sioux City, Iowa, airport. Due to outstanding risk management practices, both in the air and on the ground, of the 296 passengers and crew onboard, 184 people survived the crash. This event reaffirmed the importance of risk management planning and preparation.
1991: The spectacular bull market in Japanese stocks, The Nikkei Bubble ended, beginning a 14-year bear market.

1993: The title of Chief Risk Officer is first used by James Lam, of GE Capital, to describe the function of managing “all aspects of risk.” Today there are hundreds of CROs, globally responsible for the multiple risk management functions of their organizations.

1995: Rogue trader Nick Leeson, in Singapore, found he was disastrously overextended and managed to topple Barings Bank (known as the Queen’s Bank) within a couple of days, becoming a glaring example of insufficient financial risk management. Founded in 1762, the bank had financed the Napoleonic Wars, the Louisiana Purchase by the U.S. government, and the Erie Canal. At its demise, Barings was the oldest merchant bank in London.

1996: Risk and risk management made the best-seller book lists in North America and Europe with the publication of Peter Bernstein’s Against the Gods: The Remarkable Story of Risk. Now in paperback and translated into multiple languages, this single book, more than any preceding papers, speeches, books, or ideas popularized the understanding of risk and the attempts over the centuries to manage it.

• The Global Association of Risk Professionals (GARP) representing credit, currency, interest rate, and investment risk managers, began in New York and London. By 2002, with over 5,000 members and 17,000 associate members it had become the world’s largest risk management association.
• In the March-April issue of the Harvard Business Review, Peter Bernstein warned in his piece “The New Religion of Risk Management,” about the replacement of “old world superstitions” with a “dangerous reliance on numbers.”
• At the December meeting of the American Enterprise Institute, in discussing the strong stock market, Federal Reserve Bank Chairman Alan Greenspan said, “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”
1997: The Asian Financial Crisis (Asian Contagion) gripped much of Asia beginning in July, and raised fear of a worldwide economic meltdown (financial contagion). The IMF stepped in with a $40 billion program to stabilize the region. It resulted in President Suharto of Indonesia stepping down after 30 years in power, widespread rioting, dramatic price increases, and weakened economic conditions that lasted well into 1999.

1998: Long-Term Capital Management/Russian Crisis.

• The investment dream team of John Meriwether, former head of bond trading at Solomon Bros., Myron Scholes, and Robert C. Merton, who shared the 1997 Nobel Prize in Economics and David W. Mullins Jr., former Federal Reserve Vice-Chairman, saw the highly leveraged hedge fund they formed in 1994, Long-Term Capital Management, lose $4.6 billion in a few months.
• Despite being based on sophisticated quantitative financial models and overseen by Nobel laureates, with annualized returns of over 40 percent, before fees, in its first years, it still failed.
• In order to avoid heavy losses to its lenders and a wider collapse in the financial markets, the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the fund’s major creditors.
• After the creditors recovered their bailout investments, the fund was liquidated.
• In a far-sighted observation, some industry officials said that the Federal Reserve Bank of New York’s involvement in the rescue, however benign, would encourage large financial institutions to assume more risk, in the belief that the Federal Reserve would intervene on their behalf too, in the event of trouble.
1999: The dot.com and Internet boom reached a true feeding frenzy, even though some observers were calling it a classic bubble. To their future great regret, many investors disdained any need for risk management because “this time it’s different,” “the sky is the limit,” and “we are in a brand new era of mankind.”

2000: In a great success for risk management, the widely anticipated Y2K bug failed to materialize, mainly due to the billions spent to update software systems worldwide.

• The dot.com bubble and its “irrational exuberance” finally burst, with devastating effect on business, high-tech industries, investors, and the national economy at large.
2001: The terrorism of September 11 and the collapse of Enron reminded the world that nothing is too big to collapse. Risk management became a more important concern for everyone.

• September 11, terrorists attacked the World Trade Center Towers in New York City, and the Pentagon in Washington, DC, killing more than 3,000 people. A similar aerial attack targeting the U.S. Capitol building was prevented by passengers on the highjacked plane. Those events led to a complete shutdown of domestic air travel for several days, closure of the U.S. securities markets, and economic dislocation, and increased security.
• Closure of the New York Stock Exchange, American Stock Exchange, and NASDQ markets from September 11 until Monday, September 17, which was the longest closure of the stock markets since the Great Depression in 1933.
• When the markets reopened, the Dow Jones Industrial Average stock market index fell 684 points, or 7.1 percent, to 8920, its biggest-ever one-day point decline.
• By the end of the week, the DJIA had fallen 1369.7 points (14.3 percent), its largest one-week point drop in history. U.S. stocks lost $1.2 trillion in value for the week.
• At the end of 2001, just over three months following 9/11 the DJAI was back over 10,000.
• Fooled by Randomness: The Hidden Role of Chance in Life and in The Markets by Nicholas Taleb was published by Random House. Taleb presented the thesis that humans are often unaware of the very existence of randomness. We frequently explain random outcomes as nonrandom and view the world as more explainable than it really is. The book’s ideas have profound implications for better risk management. Later, Fortune magazine selected it as one of “The Smartest Books of All Time.”
2002: A major earthquake struck Alaska along the Denali fault, which passes directly under the Trans-Alaska Oil Pipeline, which carries up to a million barrels of oil per day. Yet, because of successful risk management in the design of the pipeline system and the quality of the maintenance, surveillance, and emergency preparedness, not a drop of oil was released, and a potential catastrophe was averted. This event served as a powerful example of the many benefits and cost effectiveness of properly executed risk management.

• Daniel Kahneman was awarded the Nobel Prize in Economics for his work in Prospect Theory and the study of judgment and decision making under uncertainty, heuristics, and biases. He and his collaborator Amos Tversky were recognized as the founders of Behavioral Economics.
2003: Space Shuttle Columbia disintegrated on re-entry after a 16-day scientific mission, killing all seven crewmembers. Although the danger of insulating foam falling off fuel tanks at launch was known to be a common problem, even before Challenger’s launch, the accident served as a vivid reminder of how even small risks, if not addressed, can have catastrophic consequences.

• Northeast U.S. Blackout, August 14, 4:15 P.M. EDT: An enormous, widespread power outage affecting 10 million people in Canada and over 40 million people in eight northeastern and mid-western states became the most widespread electrical blackout in history. The ultimate cause was determined to be a cascade of events starting with high electrical demand, tree pruning issues around power lines in Ohio, the subsequent shutdown of an Ohio power plant, a software bug that prevented alarms from alerting controllers of an energy management network, which led to the failure of primary and backup computer control systems. Fortunately power was restored the next day.
2005: Hurricane Katrina slammed into the gulf coast of Florida, Mississippi, and Louisiana. The combination of storm surge, wave action, and high winds created broad destruction, which was unusually severe in New Orleans. The storm caused nearly 2,000 fatalities, an economic loss of $125 billion, and displaced hundreds of thousands of people from their homes and workplaces.

• Because of easier financing standards, prices of U.S and European residential real estate, European, and emerging market stocks all begin to increase dramatically, attracting even more investors and speculators, driving prices higher.
2007: Nassim Taleb’s second book, The Black Swan: The Impact of the Highly Improbable, was published by Random House, became a best seller, and helped us look in a different way at how our world works. It was a warning that “our world is dominated by the extreme, unknown, and the very improbable, while we spend our time engaged in small talk, focusing on the known and repeated.”

2008: The first truly global housing, credit, and commodity bubbles all burst simultaneously. The greatest financial crisis since the Great Depression (79 years earlier) gripped the United States, then the world. It began with the bursting of the residential real estate bubble, declining home prices, tightening credit, and record numbers of adjustable rate mortgages resetting at higher rates. Those events then led to record foreclosures nationwide and their negative effect on all the highly leveraged mortgages on large numbers of homes where the mortgages exceeded the homes’ market values. Uncertainty generated by these issues then caused a collapse in the credit and lending markets nationwide.

• A nationwide $150 billion U.S. economic stimulus package was approved early in the year to help consumers jump-start the economy, but had little to no long-term positive effect.
• The U.S. Federal Reserve Bank bailed out Bear Stearns—appearing to many as an admission of failure of conventional risk management in financial institutions.
• Fannie Mae and Freddie Mac were bailed out by the U.S. Government; Lehman Brothers was allowed to default; and AIG was bailed out.
• The general confidence level of lenders dropped precipitously, leading to severely reduced lending activity and a slowing economy.
• Residential real estate prices in the United States and Western Europe extended their price declines.
• Dramatic commodity price increases (especially oil prices) began collapsing in the fall as the global economic slowdown spread and accelerated.
• The $700 billion, Troubled Asset Relief Program (TARP) was enacted.
• By October the Dow Jones Industrial Average was down over 30 percent from its high a year earlier, almost all asset classes saw large loses, and individual retirement plan and 401(k) assets levels were down dramatically.
• The U.S, economy slowed and appeared to be entering a prolonged recession.
• The Big Three U.S. automakers appeared before Congress seeking a bailout.
• December 1, the Dow Jones Industrial Average dropped 680 points, -7.7 percent in a single day, and the National Bureau of Economic Research declared the economy was in a recession and had started its economic decline in January 2008.
• Some forecasters even began talking about another depression being possible.
• Unemployment reached levels not seen in decades.
• Risk and risk management became a critically urgent issue to everyone from federal, state, and local governments, to businesses large and small, and individuals and families everywhere.
2009: The miracle on the Hudson River—On the afternoon of Thursday, January 15, Captain “Sully” Sullenberger, pilot of U.S. Air Flight 1549, and First Officer Jeffrey Skiles, with 155 people on board, accomplished a perfect emergency “splash” landing of their Airbus A320 aircraft on the Hudson River, adjacent to midtown Manhattan’s 48th Street. Along with the incredible preparedness and actions of the New York City and New Jersey emergency services response teams, everyone on the aircraft survived, and the incident was universally declared an miracle.

• More than a miracle, the entire incident was a remarkable testament to the importance and the benefits of implementing the proven risk management principals of identifying, assessing, planning for, and thoroughly preparing for risks in advance. Just a few examples:
• Captain Sullenberger’s skills and judgment gained in 19,000 hours of flight experience and service as an aviation safety expert combined with First Officer Skiles and their flight crew’s emergency situation training, turned a potential disaster into a frightening inconvenience. (Crew preparation included flight attendants trained to only open an aircraft’s front doors in a water landing, because opening the back doors, which one passenger attempted, can make the aircraft fill with water and sink much faster.)
• A320s are equipped with a ditch button in the cockpit, so just prior to a water landing the cockpit crew can hit that button and seal up the plane’s fuselage, allowing the plane to stay afloat longer; the planes are also equipped with passenger escape chutes at all aircraft doors, which also function as life rafts in case of water landings.
• In another example of thoughtful emergency contingency planning, the A320’s builders also installed an emergency power generator, called a ram-air turbine, which is designed to supply emergency power to a plane’s flight control systems in the rare event that both engines stop working, as did Flight 1549’s engines. Had that in-flight, emergency power generator not been on board or not been deployed, the pilot would have been unable to control the plane and the outcome would have been a disaster.
• The continuous emergency response training and immediate actions of the Hudson River Ferry crews, the New York City and New Jersey Police, Fire, EMTs, Coast Guard, plus all the other emergency responders was critical, given the freezing weather and icecold water conditions. As one first responder, ferry captain said, “We train, train, train, and this is where it pays off.”

Observations from the History of Risk and Risk Management

What can this historical overview teach us about risk and risk management? It’s easy, just review the ten key historical lessons about risk and risk management outlined below:

1. Instability, not stability, is the norm throughout history. Instability and progress are very closely linked. Progress leads to “creative destruction” and instability, which are byproducts of the growth and improvement in our quality of life. In essence, instability is a price of growth.

2. Surprises and rare occurrences (both positive and negative) happen all the time, should be expected, planned for, and prepared for. We know they will occur. We just don’t know when they will happen.

3. Crisis events, bubbles, busts, panics, crashes, wars, natural disasters, and all manner of surprise events are the norm throughout investment history.

4. Stability is the exception, as much as we may prefer it to be otherwise. Stability is actually very unnatural.

5. Risk cannot be eliminated. It can only be prepared for and managed. (There are risks in both acting and not acting.)

6. The pace of change in the world is accelerating, leading to increasing uncertainty, and more surprises worldwide.

7. With the complexity and interconnectedness of our world accelerating, breakdowns and accidents in our increasingly complex and worldwide systems are becoming more frequent, far-reaching, and potentially catastrophic.

8. When risks are ignored, trivialized, or danced around, they never become well managed.

9. Where risks are identified, directly faced, studied, and understood, risk management knowledge improves, leading to more effective and reliable risk management.

10. In our more complex and interconnected world, the stakes at risk have never been higher, and managing risk has never been more important.

So let’s now continue with how to actually put this knowledge to work for our own, personal risk management benefit.

CHAPTER 4

“Risk”—What Is It, and How Does It Work?

Greater knowledge of a danger creates greater safety.

Dr. Benoit Mandelbrot
The (Mis)Behavior of Markets,
Basic Books, 2004

Risk is a very broad, deep, and multidimensional subject area. It has so many aspects that it can be extremely hard to pin down. Yet having as concise as possible an understanding of what risk is, how it works, and a sense of its behavioral characteristics is one of the most important steps in effectively managing risk.

Your Definition of Risk Is Crucial

How can you effectively manage risk without first defining it and then understanding it? The more we know about risk and risk management the more effective risk managers we become. Since history has taught us over and over again that the better we understand anything the better we can control it, we must first dedicate some time to better understand the true nature of uncertainty and risk. (Although a distinction is often made between those two terms, in that risk can be measured, while uncertainty cannot, for our current purposes I treat the terms interchangeably.) Once we have a deeper understanding of our subject we can then review risk management alternatives from a much more knowledgeable perspective.

When it comes to risk, the basic definition of risk you use is the critical foundation on which your entire risk management approach will be built. With a strong and solid foundation, what you build will make your risk management job easier and more effective, serve you better, and stand the test of time. With a weak or inferior foundation, even the grandest, most sophisticated risk management methodologies will not work, and will lead to frustration, disappointment, and unnecessary loss. Now you may believe that I’m making a big deal out something quite minor. Just think a moment however, about how the old, inferior, pre-Galileo celestial mechanics definition of the universe revolving around the earth, would have greatly frustrated mankind’s space exploration efforts; about how the assumption of a flat earth stifled global exploration for centuries or even the common belief for thousands of years that man was not meant to fly, and never would. Your basic definition determines how you look at a question, and is the first step to ultimate success. It is the frame through which you view your challenge and can either complicate your efforts and restrict your success or empower and facilitate your efforts. Using the right definition is in fact, very, very important.

The Many Meanings of Risk

In their April 2002 paper “Perception of Risk Posed by Extreme Events,” prepared for the Risk Management Strategies in an Uncertain World conference in Palisades, NY, Paul Slovic and Elke U. Weber discuss the multiple concepts of risk. In other words, the term risk itself can carry different meaning depending how it is used. They cite the most common uses as:

• Risk as a hazard
• Example: “Which risks should we rank?”

• Risk as a probability
• Example: “What is the risk of getting AIDS from a contaminated needle?”

• Risk as consequences
• Example: “What is the risk of letting your parking meter expire?”
(Answer: “Getting a ticket.”)

• Risk as a potential adversity or threat
• Example: “How great is the risk of riding a motorcycle?”

With that background perspective, let’s review some of the general, high-level definitions of risk now in use:

• The possibility of harm

• Something bad might happen

• Possibility of a loss

• Negative surprise(s)

• The likelihood, impact, and timing of a negative event

• An indicator of a threat

• A possible threat

• Plus, from a different source: the probability that exposure to a hazard will lead to a negative consequence¹

With so many different potential meanings for risk in general, it is not at all surprising that people find it challenging to understand and manage risk; however, the term has even more implications when we discuss it in relationship to investments. Used in this way, risk is alternatively described as:

• Unexpected market volatility

• Variations in investment returns

• Standard deviation

• Loss of capital

• Below benchmark performance

In reviewing these concepts and definitions, do you see any common characteristics among them? How do these definitions make you feel about your ability to deal with risk? Do they empower you and give you and your risk management abilities a sense of control, or do they make you feel as though you have little or no ability to manage such a multifaceted, intangible, and sometimes amorphous phenomenon as risk? Do they provide a better understanding, or do they actually complicate understanding?

Treat the Cause Not the Symptom

The reason these definitions may not empower us is first and foremost is that they really don’t define risk as much as they describe the results of risk(s). Volatility, loss, variations of returns, negative surprises, harm, and negative consequences are the secondary or in some cases, even tertiary results of the actual risks manifesting themselves. Medical students learn very early the critical importance of treating the underlying disease rather than the symptoms, because otherwise they will never cure their patients. We need to do exactly the same thing and learn to focus on the risk itself, not the result(s) of the risk.

Using a recent, real-world example, tens of thousands of people lost their homes, and around 2,000 lost their lives, when Hurricane Katrina hit the gulf coast of the United States in 2005. New Orleans, Louisiana, experienced torrential rains, hurricane-force winds, extraordinarily high tidal surges, levy breaks, widespread flooding, and a disorganized emergency response effort. It all resulted in a catastrophe of massive proportions, with enormous human, cultural, economic, and environmental cost. Of all the various factors mentioned above, which were the actual risks and which resulted from the risk(s) occurring?

The three true risks were as follows:

1. New Orleans is almost totally surrounded by water, which averages a height of 14 feet above sea level, while much of the city is located below sea level. (The city is constantly fighting a centuries-long battle to stay dry.)

2. Hurricane Katrina itself (the 38th time a hurricane has flooded New Orleans since 1759).

3. The failure of the city’s flood protection system.²

The results of the risk were the massive flooding; tens of thousands of people losing their homes; thousands losing their lives; and the enormous human, economic, and environmental costs.

Though this is an extreme example it graphically illustrates why it is so important in risk management to focus first on risks themselves rather than be distracted by results of risk. That focus is so important because you must first identify the risk(s), then successfully avoid, prepare for, neutralize, or manage the risk, so the results of that risk occurring are either entirely prevented from occurring or dramatically reduced.

An Empowering Definition of Risk

Given those facts, where can we find a definition of risk that meets our needs? Where can we find a definition of risk that’s practical, empowering, focuses on the risks, and provides us with a high level of control? An outstanding answer came from right among the top ranks of corporate America, from the executive suite of one the best-known brands and most innovative and successful companies in the world, Apple.

Knowing that a unique definition of risk originated from a senior officer of Apple, you know it has to be something out of the ordinary, and it is. That’s likely due to the fact that Apple and this executive have been successfully dealing with enormous business opportunities and practical everyday business risks for a very long time, and along the way they have done a lot of thinking, and a lot of work, on better understanding risk and risk management. The Apple senior executive I’m talking about has been with the firm since 1996 and is currently their chief financial officer, Peter Oppenheimer. He defines risk as:

“The degree to which an outcome varies from expectation.”

Although initially that simple definition may not seem particularly profound, it is outstanding when you consider its far-reaching implications.

• It’s a tremendously empowering definition of risk. It’s empowering because although we have little to no control over the future, we alone determine our own expectations of potential outcomes based on our knowledge, understanding and preparation.

• Our expectation of the possibilities is under our control, which is not the case when we abdicate the control to totally random occurrences.

• The greatest impact typically comes from those risks that we don’t expect or aren’t prepared for.

• This definition helps us think through the full range of possibilities, both the expected and unexpected while recognizing how surprises happen all the time.

• We have total control over our expectations and full responsibility for them.

• More realistic expectations lead directly to better and more effective risk decision making and risk management.

• We have the power to ignore, accept, or prepare for what we expect.

• This definition has the flexibility to deal with both negative and positive variations from expectation.

• When we know, understand, and are prepared for risks, the very nature of that understanding and preparation converts them, should they occur, into inconveniences, and even potential opportunities.

Now that we’ve found a definition of risk that meets our objective, let’s focus in on the nature of risk and its behavioral characteristics to see what we can learn that can help us better understand risk.

Understanding the True Nature of Risk

Although we typically think of risk or uncertainty as a singular phenomenon, according to Professor Benoit Mandelbrot, in The (Mis)Behavior of Markets (2004), uncertainty is actually more complex than that.

Understanding his breakthrough perspective, however, can make an enormous difference in understanding and managing risk. The real beauty and power of his observation is that it makes what we see happening more understandable, and ultimately helps make managing risk, easier and more logical. Please allow me to explain....

After many decades of studying uncertainty in many markets, Dr. Mandelbrot (who is also renowned for inventing the newest form of geometry, fractal geometry) observed that uncertainty (risk) comes in more than one form. In fact, he came to the conclusion that instead of having only one form, uncertainty actually has three forms or “states.” Initially that concept may seem a little hard to grasp. However, multiple states or forms are a quite common natural phenomenon. A tangible example of this characteristic is the very physical matter that composes our world and the entire universe. At a fundamental level, all matter has three basic states: gas, liquid, and solid. Just as water has three distinct states, ice, liquid, and gas (steam), with each phase exhibiting very different physical properties and behavioral characteristics from one another. Dr. Mandelbrot has identified three different states of uncertainty. Each of the states exhibits properties and characteristics as different from one another as ice, liquid water, and steam are from each other, even though they are all H₂O. The three states of risk identified by Professor Mandelbrot are mild, slow, and wild uncertainty.

The States of Risk

Doctor Mandelbrot’s breakthrough description of risk in his book The (Mis) Behavior of Markets, 2004 is a classic example of thinking outside the box and the power of unbiased, scientific observation. Pointing out the similarities between the multiphase states of matter and the multiple phases of uncertainty and risk, he clarifies risk in a fundamental and important way. Once you become familiar with the three phases of risk he describes in The (Mis) Behavior of Markets, 2004, which are reviewed below, you’ll never be able to look at risk the old way again.

Mild uncertainty is like the risk in calling a series of coin tosses. This form of risk/uncertainty adheres to the normal bell distribution. It has well defined parameters, low variability, no big surprises, and is predictable. Dr. Mandelbrot says that it “is like the solid state of matter because it has low energy and stays where you put it.” It is the kind of risk, price variability, and volatility that are periodically found during normal, random walk stock market periods. In his thought-leading 2007 book The Black Swan, Nassim Taleb characterizes this type of uncertainty as Type 1 randomness. Among the examples of this type of uncertainty he cites in that book are the height, weight, and calorie consumption of people, car accident rates, mortality rates, and IQ. This type of risk is characterized by the routine, the obvious, and the predicted.

Wild uncertainty is the opposite of the mild form. It is unpredictable, irregular, outside what is normally expected, high energy, not structured, and has fast seemingly limitless and frightening fluctuations from one value to the next. In his book, Professor Mandelbrot states that “its like the gaseous phase of matter, no structure, no volume, no telling what it will do.” This form of risk is typical of extreme, highly unstable, hypervolatile stock markets like the one in the fall of 2008. Nassim Taleb, in The Black Swan, also provides examples of this type of randomness. Examples of what he calls Type 2 randomness are the enormous range of wealth, personal income, book sales, name recognition as a celebrity, damage caused by earthquakes, deaths in war, death in terrorist incidents, financial markets, commodity markets, and inflation rates. This risk type is subject to the accidental, the unseen, the unpredicted, surprises, and the extreme.

Slow uncertainty is the form of risk between mild and wild. Dr. Mandelbrot describes it as like the liquid state of matter.

Looking at risk and uncertainty in this multistate way, with each state of risk having different behavioral characteristics can be an enormous advantage in helping us understand not just the way risk works, but also the world we live in, the wide variances we can experience, and the range of market behaviors we can expect over time. It can also greatly help us in determining and implementing effective risk management methodologies.

Now that we have a practical, empowering definition of risk, and an understanding of the various types of risk and their behavioral characteristics, let’s now direct our focus toward risk management.

CHAPTER 5

Which “School” of Risk Management Is Best?

The feeling of having done a job well is rewarding; the feeling of having done it perfectly is fatal.

Donley Feddersen

Rarely do we humans agree on there being only one right way to do things, and managing risk is no exception. Over time, numerous approaches to risk management have been attempted, with some more effective in certain situations than others. As time has progressed, these many different approaches have evolved into a couple of basic philosophies or schools of thought as to the best and most effective way to manage risk. This chapter objectively examines each of those “schools” of risk management to determine which is most effective for our use as individual investors. Before beginning that study however, we need to make certain we are very clear on exactly what we mean when we use the term risk management.

What Is Risk Management?

What characteristics do we want to see in a good definition of the management of risk? Besides being as brief as possible, it must be compatible with the following six statements:

1. Risk is not about the past or the present, but about the future.

2. The future offers no certainty, and as much as we hope or plan on it developing in a certain way, we really don’t know what it will bring.

3. Risk is a measure of possibility and potential impact.

4. Risk can lead to a range of both good and bad possible outcomes.

5. Those outcomes can be mild or wild, and can include possibilities of extreme events that we can’t even imagine (e.g., Black Swans).

6. Risk is a relative phenomenon, meaning that even when two people are both facing the same situation at the same time, the risk to one person is often entirely different from the risk to another. (This difference is caused by a number of factors including each individual’s age, experience, level of exposure, understanding, knowledge, and confidence level when facing a threat, as well as their level of preparation.)

Considering all these factors let’s consider a few different definitions of risk management, starting at the highest and most all encompassing level. The high-level definition of risk management developed by Felix Kloman, lifelong student of risk management, former risk management consultant and corporate chief risk officer (CRO), and worldwide authority on risk management, is outstanding. In his book, The Fantods of Risk, Seawrack Press, 2008, he shares this definition:

Risk Management is a discipline for dealing with uncertainty.

Another, somewhat more detailed definition incorporates the importance of risk exposure analysis and using a process-based approach. It comes from the InvestorWords.com online investment dictionary. There, risk management is defined as:

The process of analyzing exposure to risk and determining how to best handle such exposure.

Also, with risk management professionals in Australia and New Zealand being among the true thought leaders on risk management issues, the Australian Standards/New Zealand Standards 4360:2004 articulates a definition that recognizes the universal interlocking relationship of risk and reward, and the importance of using a risk management process and embracing a risk conscious culture. That definition reads:

Risk Management is the culture, processes and structures that are directed toward realizing potential opportunities while managing adverse effects.

For our purposes, the last definition may be the best because it highlights the five key elements of any successful risk management effort:

1. A focus on the future

2. A culture where risk is always kept in mind

3. The development of a risk management process to build consistency and effectiveness

4. Decisions that are based on a balanced understanding of both potential rewards and the potential risks

5. Advance preparation for potential adverse effects and potential opportunities

Risk management at its most fundamental starts with a continuous awareness of possible risk because surprises happen all the time. Then, after building on that foundation, comes the next step of determining what, if anything, needs to be done to avoid, prevent, or manage the risks identified, as well as initiatives to minimize their impact should any of them occur.

The Big Question

Over many years, two very different approaches, philosophies, or “schools” of risk management have developed. One has evolved and been used successfully over the last thousand or so years; the other has gained prominence, popularity, and widespread use in just the last half century. Proponents of each of these different risk management approaches tend to be dedicated believers in their particular method. They are strong proponents of what they perceive to be their chosen philosophy’s numerous advantages and superiority over what they see as the inferior qualities of the other. The acolytes of these two, polar-opposite risk management “schools” are very adamant in their views and have rather heated debate with one another as a result. We, however, will explore and get to know both of them.

Given that no one approach is perfect and there are advantages and strengths, as well as disadvantages or weaknesses to any “school,” rather than just select one or the other, we’ll explore how we may be able to exploit the advantages and minimize the weaknesses of each approach. You should become more familiar with both methods and better able to manage the risks you face more effectively than investors who doggedly adhere to just one philosophy or the other.

Let’s first look at the foundational underpinning of each of the risk management “schools” independently. We’ll follow that examination with a dive into the nature of risk itself. Then we’ll circle back to review how both these two opposing approaches to risk management can benefit your risk management effectiveness. Capitalizing on each one’s strengths while minimizing their weaknesses will give you a big advantage as you pursue becoming an even more knowledgeable and effective “Risk-Wise” Investor.

Quantitative versus Subjective

The two schools of risk management are the quantitative school and the subjective or qualitative school of risk management. The quant school is embraced by those who see quantification of past occurrences, relationships, trends, correlations, mathematical relationships, and numbers as the best way to make risk/reward decisions about the future. By contrast, the Qualitative School encompasses those who believe that in a rapidly changing world it is more effective to base risk/reward decisions on subjective degrees of belief about a subjective future rather than relying exclusively on quantifications of the past. With just that short description, it should be easy to appreciate how controversy and tension have developed between these two very different approaches to risk management.

As our first step, let’s review the most dominant investment risk management approach used today, the quantitative risk management method. We’ll explore what it is, how it works, and some of its history. When we’ve completed that exercise with the quantitative approach we’ll shift our attention to the qualitative or subjective risk management method, and go through the same process. Once you have a good understanding of both approaches, and with an understanding of the fundamental nature of risk (see Chapter 4), we’ll review how both risk management methods may be use in concert to enhance your investment risk management effectiveness.

Trust the Numbers?

The quantitative approach to risk management initially evolved out of efforts in the late Renaissance to gain an advantage in gambling by better understanding the internal workings of games of chance. Quantitative techniques accelerated their early development in the mid-1600s with the expanding use of the more sophisticated mathematics made possible by the “new” Arabic numbering system. During that period, Blaise Pascal and Pierre de Fermat developed their concepts of calculating probabilities of chance events, based on gambling. They were followed in the early 1700s by Jacob Bernoulli’s development of statistical sampling techniques, and the Law of Large Numbers. Bernoulli was then followed by Abraham de Moivre and his bell curve and then by Daniel Bernoulli (Jacob’s younger brother) and his application of the concept of “utility” to risk decision making. In the 1800s Frederick Gauss worked out his more detailed analytics of the bell curve, and Francis Galton discovered, then articulated the natural process of regression to the mean and its application to business analysis and risk/reward decision making.

The quantitative method of risk management and its potential applications in the investment world gained a big surge in momentum in 1952 with the work of Harry Markowitz on return and variance in investment portfolios, on the efficient frontier, and on why diversification works. Then in 1964, Bill Sharpe introduced his capital asset pricing model and the Sharpe ratio that is still widely used today to characterize how well the return of an investment compensates the investor for the risk taken. With its comprehensive set of theories and mathematical elegance, the quantitative approach was subsequently embraced by the academic community and within a decade by the investment management world. The quantitative approach received still further reinforcement when in 1973, Fischer Black and Myron Scholes jointly showed how to accurately value stock options, just before the opening of the first true stock options exchange, the Chicago Board Options Exchange (CBOE) in 1974.

The quantitative approach to risk management including the “capital asset pricing model,” “modern portfolio theory,” “the efficient frontier,” and defining risk using the statistical term standard deviation, all became mainstream. Its approach to constructing, monitoring, and adjusting investment portfolios based on mathematical formulae, numerical technical measures such as alpha, beta, Sharpe Ratios, and correlation coefficients made investment management and risk management seem much more like a science than an art. The quant method when embraced, promulgated, and perpetuated by academicians, became virtually the only method of investment risk management that has been taught in our universities and business schools over the last 30 years.

The quantitative approach has also become the default risk management approach of the majority of the global investment community. This quantification seems so logical, neat, tight, tidy, and well . . . appealing. It’s so gratifying and reassuring to see the highly complex, ever changing, and complex, multidisciplinary subjects of risk and uncertainty reduced to rock-solid numbers and mathematical equations that allow us to manage risk more effectively than ever. Maybe Benjamin Disraeli was wrong when he remarked, “There are three kinds of lies—lies, damned lies, and statistics.”

There, is however, one important question we have to ask ourselves: Has what works in theory and elegant equations actually worked in the real world? Fortunately, we now have over three decades of real-world experience to show us how well it works. Unfortunately, the real-world experience in using the quantitative risk management method has been mixed. Quite simply, what works beautifully in theory, in reality works sometimes and sometimes doesn’t work well at all. In fact, the quantitative method works well in routine and reasonably stable markets (periods of mild uncertainty). When this approach tends not to work well or becomes less effective is when markets begin behaving badly, when volatility increases, previously established relationships begin rapidly changing, and instability raises its ugly head (periods of wild risk). Of course, that is exactly when investors need effective risk management the most.

Now let’s examine some of the assumptions that form the foundation of the quantitative theories and hypotheses.

Basic Assumptions Behind the Quantitative Risk Management Approach

While examining some of the basic assumptions behind the quantitative risk management approach, be sure to keep in mind that since there are literally thousands of real-world variables that impact investment and portfolio performance, assumptions must be made by the quantitative theoreticians to simplify the math enough to make the theoretical numbers work. However, if these assumptions are in fact inaccurate, then the entire structure built on them must be called into doubt.

Here are six assumptions on which the quantitative method depends:

1. The past is the best model for the future. So looking backwards is the best way to determine the future.

2. The efficient frontier is a valuable tool for determining the optimum asset allocation to maximize return and minimize risk in the future.

3. All price variations follow the standard bell curve distribution pattern.

4. Each value (trade/price) is independent of the previous or subsequent value (trade).

5. Markets are always efficient at determining the true value of a security.

6. Investors are always rational.

Strengths of the Quantitative Approach

The quantitative school of risk management has some very compelling advantages, including the following five:

1. An enormous amount of current and historic data available for analysis

2. Theoretical logic

3. Mathematical elegance

4. Excellent applications for use with computers

5. Practical applications in portfolio construction

Investment Reality

In reality, the quantitative method of risk management works reasonably well in normal markets, but has broken down, and has over and over again disappointed investors, when markets begin to change rapidly and extreme volatility raises its ugly head.

Another reality is that although future financial markets will have some things in common with past financial markets, the future will be different from the past (and at times behave very differently). So, relying too heavily on past relationships and trends in managing risks in the future, during the most rapidly changing period in human history, is a recipe for disaster.

Additionally the quantitatively based efficient frontier model of asset allocation (which defines a portfolio being efficient when it produces the most profit with the least risk) looks solid and stable over the 48-year time horizon presented in Figure 5.1. But when you examine the numbers decade by decade as in Figure 5.2, it’s an entirely different story.

Figure 5.1 depicts the efficient frontier of equity and bond portfolios illustrated in 10 percent increments. Equity returns are based on the returns of the S&P 500 Index, which includes the reinvestment of dividends. Bond returns include the reinvestment of interest and are based on the Barclays Capital Aggregate Bond Index.

FIGURE 5.1 The Efficient Frontier 1960-2008 (48 years)

Source: Reprinted by permission from Rydex Investments 2008.

FIGURE 5.2 The Efficient Frontier Decade by Decade (1960-2008)

Source: Reprinted by permission from Rydex Investments 2008.

The standard deviation axis of the chart in Figure 5.1 represents annual portfolio volatility (sometimes volatility of returns is also called “risk”) and the annual return axis represent annual percent returns. Each of the symbols represents a 10 percent change in the equity (stock)/bond mix between a 100 percent equity portfolio at one extreme, a 50 percent equity/50 percent bond portfolio in the middle and a 100 percent bond portfolio at the other extreme. In this example, a mix of 30-40 percent bonds and 60-70 percent stocks provided the best return for the least risk over the 47-year time frame.

However, when you look at shorter, decade-long time horizons, you see a highly variable and ever-changing environment. As you can see in Figure 5.2, the efficient frontier has moved around dramatically from decade to decade over the last 47 years. In fact, in the nine years from 2000 through 2008 the efficient frontier actually inverted (which is very unusual), so that a portfolio of 100 percent bonds actually generated a higher return with less risk than a portfolio composed of 40 percent fixed income and 60 percent equities. That constantly changing range of risk (standard deviation) and return in the relative performance of stocks and bonds over decade-long time frames can be very unsettling and quite a challenge for individual investors with shorter investment time horizons (20 years and under) and possible interim liquidity needs.

Figure 5.2 depicts the efficient frontier of equity and bond portfolios illustrated in 10 percent increments. Equity returns are based on the returns of the S&P 500 Index, which includes the reinvestment of dividends. Bond returns include the reinvestment of interest and are based on the Barclays Capital Aggregate Bond Index.

The standard deviation axis of the chart represents annual portfolio volatility (sometimes volatility of returns is also called “risk”), and the annual return axis represents annual percent returns. Each of the symbols represents a 10 percent change in the equity (stock)/bond mix between a 100 percent equity portfolio at one extreme, a 50 percent equity/50 percent bond portfolio in the middle, and a 100 percent bond portfolio at the other extreme. In this example, a mix of 70 percent bonds and 30 percent stocks provided the best return for the least risk over the last 9-year time frame.

On a decade-by-decade basis there are dramatic changes to the shape, risk, and return of the efficient frontier that are masked by looking at only the longer 47-year institutional time frame.

All price variations do not follow the standard bell curve (mild risk/Type 1 uncertainty) distributions depicted in Figure 5.3

In reality, wild risk, outliers, black swans, and tail risk are real and happen with unpleasant regularity, even though modern finance theory assumes that only mild randomness exists.

FIGURE 5.3 The Normal Distribution Bell Curve, with Standard Deviations Indicated

Figure 5.3 shows a classic representation of the normal bell curve distribution. The vertical axis represents the number of occurrences of each particular random sample value, and the horizontal axis represents both the positive and negative distribution of samples around the mean, with 1 standard deviation either (+) or (-) encompassing 68.2 percent (34.1 + 34.1) of all values. 27.2 percent (+13.6 percent + (-)13.6 percent) representing 2 standard deviations, and so on.

In his 2004 book, The (Mis) Behavior of Markets, Dr. Benoit Mandelbrot pointed out some specific examples of how the normal distribution depicted in Figure 5.3 is not an accurate explanation of reality of uncertainty in the securities market.

Reviewing Table 5.1, it’s clear that bell curve theory does not reflect reality in the investment world. As an example, bell curve theory predicts a greater than 4.5 percent daily market move occurring only 6 days in 87 years (which is approximately 21,750 days) or .027 percent of the time. When in fact from 1916 through 2003 the Dow Jones Industrial Average experienced a daily move greater than 4.5 percent 366 times (on average, about 4.2 days every year for 87 years, or about 1.7 percent of the time). That’s about 60 times more frequently than theory predicts. So clearly theory does not reflect reality. Dr. Mandelbrot’s examples demonstrate that real-world events inconveniently expose the bell curve as being not up to the job of properly representing the brand of wild uncertainty found in the investment markets.

Additionally, reality demonstrates the some of the assumptions necessary to make the quantitative model function are flawed. As examples consider:

• Although quantitative theory assumes that each value or price change of a security is independent from the previous value, reality inconveniently demonstrates that security trades are not independent of one another and can and do impact the next value. In fact, very often a previous security price movement or string of price movements will impact the next and following price movements (which theory assumes does not occur).
TABLE 5.1 Real-World Examples—Dow Jones Industrial Average 1916-2003 (87 years)

Source: The (Mis)Behavior of MarketsbyBenoitMandelbrot,p.13,copyright © 2004.Reprinted by permission, Basic Books, a member of the Perseus Group.

• Quantitative theory assumes that market are always efficient, while reality demonstrates that markets are efficient sometimes and very inefficient other times. (Generally speaking free markets are efficient pricing mechanisms. However, many times individual securities as well as markets can become extremely oversold or overbought, and very inefficient pricing mechanisms develop in those situations where emotion rule over logic.)

• Investors are not always rational. They are both rational and emotional beings. At times they are quite rational and at other times their emotions override their logic, and they become irrationally exuberant or irrationally pessimistic.

Therefore as elegant as the quantitative method is theoretically, it just doesn’t hold up and in fact becomes inelegant under the intense light of investment reality.

Sample of Weaknesses in the Quantitative Risk Management Approach

The fundamental weakness of quantitative method is that its calculations are based on the flawed model of reality represented by the bell curve. In fact its flaws are most obvious when extreme market moves occur, and risk management is needed the most. Following are some examples.

For individual investors, the major decade-by-decade shifting of the efficient frontier’s shape, risk/reward levels, and optimum asset mix visibly demonstrates this weakness because the future is frequently very different from the past. This finding is evidenced by the time periods listed here:

• See the 2000-2008 period in Fig.5.2 where the efficient frontier “fish-hook” actually inverts and a portfolio of 100 percent bonds provides an almost four times higher return with less volatility than a portfolio of 100 percent equities over a nine year period of time.

• Also in Fig.5.2 see 1970-1979 when there was effectively no difference in return between a portfolio of 100 percent equities and a portfolio of 100 percent bonds although the bond portfolio enjoyed over 50 percent less price volatility than the equity portfolio.

• October 1987: Quantitatively based portfolio insurance was completely discredited because it dramatically failed to deliver the downside protection it was calculated to deliver.

• Fall 1998: The hedge fund Long-tem Capital Management collapsed, even though it counted among its partners and founders two winners of the Nobel Prize for their quantitative expertise.

• December 2006: Bill Sharpe, original developer of CAPM, published a new book Investors and Markets articulating—his flexibility is admirable—that he now prefers a “state/preference” approach to his original capital asset pricing model (CAPM) because his newly favored scenario-based approach allows for unforeseen crisis events and wild risk, which CAPM does not.

• October-November 2008: The historic, gut-wrenching, hypervolatile market meltdown, across almost all asset classes (foreign and domestic) and the bursting of the housing bubble, credit bubble, and commodities bubble, demonstrate the flaws in using the backward-looking, quantitative risk management approach as an effective risk management method during periods of wild/Type 2 risk.

Quantitative Risk Management Approach Summary

In summary, the quant school approach can be helpful in constructing portfolios and managing risk in generally normal (mild risk) market conditions. However, its effectiveness breaks down and becomes ineffective at managing risks during extreme (wild risk) market conditions or when previous market patterns and relationships are changing rapidly. The numbers, mathematical formulae, and apparent rigor of the quantitative method can easily entice investors into trusting it implicitly. If you’re not familiar with its track record and flaws, it is very easy to believe that its theories, models, and analytics have neutralized uncertainty and tamed investment risk in all market environments, which is demonstrably not the case.

Trust Your Gut?

The subjective or qualitative approach to risk management is a very natural and intuitive method of risk management. It’s not a numbers based method. In fact, it has a great deal in common with the way we adult humans manage our everyday life risks. The qualitative school is based on the belief that since the world is always changing and every situation is different, it is more effective to base risk/reward decisions on subjective degrees of belief about a subjective future rather than on observations of the past. Although the past can be helpful in making decisions about the future, that knowledge and experience when combined with a forward-looking view and sound judgment will improve the quality of our risk/reward decision making and overall risk management success.

The heart of the subjective method is probably best described by combining the essence of the precept I introduced in the Preface of this book: “What we know, understand, and are prepared for cannot harm us,” and utilizing the full potential of the empowering definition of risk provided by Peter Oppenheimer we reviewed in chapter 4, where your “risk is the degree to which and outcome varies from (your) expectation.” By combining and implementing these two foundational observations, we become focused on building our knowledge and understanding of risk, developing more realistic expectations, and better preparing for the risks we expect and even the ones we don’t. This improvement in knowledge, understanding, and preparation, provides us more comfort, control, flexibility and fewer surprises in dealing the risks we’ll face.

Basic Assumptions Behind the Qualitative Risk Management Approach

In reviewing the eight qualitative model’s assumptions in the following list you’ll see they are generally broader, more flexible, personal, and practical than the quantitative model’s assumptions.

1. Looks forward while referencing (but not exclusively) past experience and practical knowledge.

2. Naturally skeptical, avoids reliance on any one method or possible outcome.

3. Assimilates the reality that both negative and positive surprises can be expected.

4. Incorporates current information and forward-looking judgment.

5. By directly facing possible risks, studying them, and working to understand their nature and character, risks can be more successfully managed.

6. The more you know about a risk, the better decisions they’ll make.

7. Make realistic, knowledge-based assumptions in evaluating the range of possibilities, risk mitigation alternatives, and risk/reward tradeoffs.

8. Recognize that risk and risk reward decision making is a very personal and subjective process.

Strengths of the Qualitative/Subjective Approach

As you would suspect, the 10 strengths of the qualitative system outlined here confirm its practicality, flexibility, and ability to factor in personal judgment:

1. Forward looking

2. Flexible and easy to adapt and/or incorporate new information or situations

3. Experience, knowledge and judgment can be incorporated in decision making

4. Not as constrained by an over-reliance on only numbers, formulae and the risk of using flawed assumptions necessary to make the model work

5. Leverages our own well developed, life-risk management experience and skills

6. Easy to understand and implement

7. A straightforward, user-friendly, and intuitive method

8. Complements our control over what we expect, including expecting the unexpected

9. Works in both mild and wild risk conditions

10. Recognizes that we each can understand and manage our own unique and ever-changing, personal risk management priorities better than anyone else

Investment Reality

Although certainly not perfect, over the thousands of years humans have used and improved it, the qualitative method has demonstrated its applicability in all market conditions. Its functionality and success are directly related to the familiarity and understanding of its users with the nature of the risks expected, and the time and resources those individuals have to prepare for those risks. Its flexibility and ease of use make it an attractive risk management alternative.

Sample Weaknesses of the Qualitative/Subjective Approach

The qualitative approach’s four prinipal weaknesses are:

1. Requires an initial basic knowledge of how to use it

2. Requires an effort to stay current on the business, economic, and geopolitical environment

3. Cannot manage risks that are not expected (just like quantitative method)

4. Cannot predict timing of a risk, but can predict its existence and potential personal impact

Qualitative Risk Management Approach Summary

The qualitative approach incorporates the often misunderstood problem that the risk/reward tradeoff can often be very different from one person to the next. The level of risk can vary dramatically based on an individual’s own knowledge, skill, experience, and exposure in dealing with a risk. The actual risk each individual takes, even when facing an identical threat, can range widely from little to enormous risk. The subjective risk/reward analysis can also be influenced by the relative value of what one can potentially lose versus what might gain in taking a given risk. (Remember Daniel Bernoulli’s utility theory: One with more to lose sees a risk/reward decision as less attractive than one with very little to lose, even though they are both looking at the same potential gain.) The qualitative method also benefits from both an individual’s logical and intuitive decision-making processes. Often, with enough information knowledge, and experience, and after weighing all the factors, trusting your gut can be a very effective risk management decision-making strategy.

It is important to keep in mind that the subjective risk management method should not be confused with the practice of guessing. It’s not guessing when you’re using familiarity, knowledge, and/or personal experience as the basis for your risk management decision-making process or when using the advice of an expert who’s knowledgeable in the discipline appropriate to the decision. Of course, it is definitely guessing, and should always be avoided, when you’re tempted to make a risk management decision with little knowledge, practical experience, or expert advice. In cases where you are making a risk management decision and lack the appropriate knowledge or have insufficient information, the decision should either be deferred until your knowledge/information gap is rectified or a knowledgeable subject-matter expert can be consulted.

Two Is Often Better than One

Given that each of these approaches to risk management has both advantages and disadvantages, which school of risk management is best? Like so many other things in life, that depends on you. Remember what I mentioned earlier in this book about how critical it is, for the success of any risk management method, that each one of us know, thoroughly understand are comfortable with, and have confidence in the method we use (understanding both its strengths and weaknesses). If you are an engineer, statistician, mathematician, or are quantitatively oriented and more comfortable with the quantitative method, then by all means use it. If, on the other hand, you are more intuitive, have business and investment experience, confidence in your business judgment and experience, stay current on the business and investment worlds, and prefer more personal control and flexibility, then the subjective method will be the best for you.

The very best way to proceed may be using both methods at the same time because they complement one another so well. The quantitative method is helpful in portfolio construction and works well in mild risk environments, whereas the qualitative method is more intuitive and more effective during the inevitable periods of wild risk. In addition, the subjective approach gives more control in terms of what risks are expected (even in planning for rare or unexpected risk too) and how to specifically avoid, manage, or accept those risks. Another way to benefit from both schools of risk management is to use quantitative techniques for periodic portfolio rebalancing, while using the qualitative approach to manage big picture risks and for making the occasional tactical decisions to defensively raise cash, hedge, or become more aggressive when appropriate. Just as diversification is a proven risk reduction technique in portfolio construction, and one can reduce overall portfolio risk further by owning stocks-bonds-cash, value and growth, large capitalization stocks and small caps, domestic and international, it makes the same sense to diversify your risk management methods as well.

CHAPTER 6

How Your Body Can Work Against You

Our civilization is still in the middle stage, scarcely beast, in that it is no longer guided by instinct, scarcely human in that it is not yet wholly guided by reason.

Theodore Dreiser in Sister Carrie, 1900

Why do investors invest with confidence, enthusiasm, and even euphoria when markets are advancing, yet avoid investing when those same assets drop in price? Why are investment returns typically higher than investor returns? Why do we love to buy cars, TVs, clothing, and all manner of consumer merchandise on sale yet are appalled at the thought of buying investments when they are down in price and on sale? We’ll explore answers to these age-old questions as well as many others in the next few chapters.

Both Beast and Human

Even though humans are the most knowledgeable and advanced creatures to have ever existed, at the most fundamental level we’re still animals. We are composed of two different natures. As Theodore Dreiser points out, we’re “scarcely beast and scarcely human.” Our higher thinking powers are continuously in battle with our basic animalistic tendencies and ingrained instincts, working to rein them in. Most of the time these conflicting forces balance against one another. In extreme situations however, our animal nature often overtakes our higher logical nature, which many times leads to trouble. Investing is one of our human activities that can bring out the full range of our animalistic and emotional extremes. Although experienced investment practitioners strongly advise against letting emotions and feelings impact investment decision making, it is extremely difficult for even savvy investors to do so because emotions and feeling are such an integral part of our everyday human decision making. In fact, almost anyone who is even briefly exposed to the investment world is struck with how emotionally charged investing can be. Our own basic instincts and emotions, as well as those same instincts in the universe of all other investors, play a critical role in whether we succumb to investment pitfalls or maximize our investment opportunities and enjoy long-term financial success. Greed, hope, fear, denial, remorse, pride, joy, anger, despondency, avarice, and all our basic survival instincts are commonplace in our modern investing landscape. Sometimes you can even see all of these various phenomena in the investment markets within as short a time frame as 24 hours. Although we continually strive to use our higher powers of logic to rise above our base animal instincts and raw emotions, those base instincts can many times overwhelm us to the point where we can become our own worst enemies. In answering the big questions of why and how this happens and how can it be avoided, we must first invest our time in better understanding the functioning of our own bodies, brains, and minds—and how they interact. Once we become familiar with and understand those details, we’ll be better prepared to deal effectively with those situations where our bodies and/or our brains are working against our own best long-term investment interests.

Our bodies are amazing in their capabilities, complexity, adaptability, and incredible self-healing power. Think about all our highly integrated organ systems. They range from food processing, nutrient distribution and waste removal, information collection and analysis to temperature stabilization, advanced and integrated communications capabilities, to reproduction, threat analysis and risk response systems, all operating so well that we don’t even have to think about them. Even though modern medicine has learned a tremendous amount about how our bodies work, there is still so much more to learn that tens of thousands of scientists all over the world are dedicating their lives to advancing our knowledge, and they know their work will go on indefinitely.

Model T Biology in the Internet Age

Our bodies have developed enormously sophisticated hard-wired automatic, reflex systems to control our blood sugar and oxygen levels, heart rate, hormone levels, and literally thousands of other substances in order to give us the maximum opportunity to survive, reproduce, and prosper in the natural world. These natural, built-in capabilities have given us an incredible advantage in dealing with the challenges of the world our species has faced as humans have navigated through their daily lives throughout history. As wonderful, amazing, and powerful as these automatic systems and built-in hardwiring are, it is very, very important to understand how they can easily cause us to act against our best interests in the non-natural world of investments.

Those same very strong, automatic systems that developed to help us survive and prosper in the natural world can often work against us because our biology has been left in the dust by the enormous advances we’ve made in the development of our modern lives in just the last few hundred years. Our bodies have been preprogrammed for a hunter-gatherer life style and the risks and threats of the natural world our distant ancestors faced and dealt with for more than 50,000 years. Now, however, we live in an incredibly different, extremely fast-paced world with a completely new array of challenges and issues where our Model T biology is working overtime to help us survive and prosper in our super mobile, multitasking Internet/high-tech /space age. That divergence creates a number of challenges that are critical to understand if we want to manage those internally generated risks. It is somewhat like the issues you might run into were you to use computer punch cards to load software on a state-of-the-art super computer or to connect your old trusty analog TV to a high definition video feed. The old technology will have trouble adapting to the new reality. Fortunately, we are a very smart, fast-learning species and have been able to adapt in many ways. However, the investment world in particular offers special challenges and common pitfalls directly resulting from the gap between our hard-wired biology and the realities of the modern investment world, which “Risk-Wise” Investors need to address. These include pitfalls that are directly related to the automatic reflexes built into the internal hardwiring of our brain and our body/brain interface.

Understand the Enemy Within

The best way to face these challenges is to continue to apply the fundamental philosophy of “Risk-Wise” investing to the special class of investment risks that originate inside our own bodies. Our true enemies within. (Remember that the best way to understand and manage risks is to face them directly, get to know them, and understand as much about them as you can. Because the more you know and understand about risks, the better decisions you’ll make in identifying, avoiding, neutralizing and/or managing them.)

We’ll start by identifying these ingrained, preprogrammed, internal risks. Then we’ll review each one in more detail. The ultimate objective is to help you to better identify, understand, prepare for, and effectively manage any of these risks when they manifest themselves. However, there’s both good news and bad news on this subject. The good news is that because most of these risks involve your own internal decision-making ability, they are totally under your own control. The bad news is that because they are instinctive, hard-wired, and automatic ways of thinking/reacting, it’s very easy to be influenced by them, and it can be extremely challenging to overcome them. Fortunately, just the knowledge of their existence and an understanding of when and how they activate can help you manage or avoid these internal decision-making traps more easily.

The ingrained, internal risk factors we’ll highlight and review in more detail in this chapter are:

• Misunderstanding the non-natural characteristics of the investment world

• How your brain works for you and can work against you

The internal risk factors we’ll review in subsequent chapters include the perception versus reality gap, the herd instinct, ingrained decision-making biases, pattern finding in randomness, and the extrapolation trap.

The Non-Natural World of Investing

It is critical to emphasize the importance of taking into full account and understanding the basic fact that human beings have been hard-wired by evolution over tens of thousands of years to deal with the risks, rewards, and realities of life in the harsh, natural world we humans have lived in for over 98 percent of human existence. Our innate physiology and behavior were formed in the unforgiving natural world where the focus of life was on surviving from day to day, and on only the here and the now. It was an environment full of countless challenges and dangers, including bloodthirsty beasts that viewed human beings more as prey than predators. It demanded focusing on the present, because the past and the future had absolutely no relevance. It was typically a life of feast or famine with relatively calm periods periodically peppered with short, surprising, highly stressful, life-threatening situations that ingrained the instinctive freeze, flight, or fight responses that we still posses today. The only priority was to focus on the daily struggle to pull through and live for one more day. Early humans’ bodies and brains evolved to survive in that demanding, now-focused, survival-of-the-fittest kind of world. Even though our world has improved dramatically in the last few hundred years, that ancient hard-wiring still serves us reasonably well in dealing with the challenges we face in our day-to-day, natural existence. Of course, we also now live with new, persistent, and potentially more harmful global risks that our progenitors could never have imagined. However, dealing with those newer risks is a subject we’ll return to later.

Investing does not operate in a natural-world setting. Instead, investing exists in a non-natural world, and the big difference is related to time. Unlike the real, natural world where we spend a lot of time and effort to hold onto and preserve the past, while living and taking action in the present, the investment world is not at all about the past or even the present. Investing is all about and only about the future. Investing is not about what happened yesterday or even what is happening now. The non-natural investment world is all about the future and what is likely to happen in that future. The past, and even the present, may offer a convenient reference on the future, but the future will always be different from that past. To successful investors, spending too much effort on the past and even the present is pure folly, an enormous distraction, and an extremely seductive trap. Most investors, analysts, and the press spend a great deal of time, energy, and effort focusing on and analyzing the past and the present, and not nearly enough time on the future and what is most realistically likely to happen over most investors’ longer-term investment timeframes. When it comes right down to it, true investors are not investing today for today or even today for tomorrow. (Traders and speculators may take very short-term positions with the intention of benefiting from a few percentage points’ move, but that’s not investing. Those short-term speculators and trader are, pure and simple, just gambling. You’ll also find that their ultimate long-term success is also about the same, and about as disappointing, as any gambler’s.) When you are truly investing today, you are investing in anticipation of a world 3, 4, 5, 10, 15, or 20-plus years from today. In that future world, today’s news, market fluctuations, movers and shakers, and screaming headlines will be totally forgotten, and have become inconsequential and unimportant random historic noise.

Now that’s exactly the opposite of what the business and investment news programs and much of the financial pundits want you to believe. Their objective is to generate as many advertising dollars for their programs as possible by keeping as many eyeballs glued to their programs as possible. They are breathless, urgent, emotional, and unsettling because they want you to appeal to your animal brain and keep you focused on what the markets will be doing in the next minute, hour, day, or week. How successful would their programs be if at the end of the business day, they announced that the stock market was down 200 points today, but in the great scheme of things, it really doesn’t matter for long-term investors?

As a result of our brain being preprogrammed for risk management in the right-now natural world and successful investing requiring a modified future-forward approach to risk management, our ancient and trusted, internal, natural-world, hard-wired risk management circuits and automatic responses run into real difficulty in the non-natural world of investing. I use the term non-natural because the investment world is a very different world in a number of important ways, and it requires a different set of success skills from the natural world where we spend the majority of our time. It is a critically important point to understand, because our natural-world hard-wiring just can’t be as effective operating in a non-natural world that’s so different from the one it was originally developed to address. That mismatch between the ingrained methods we use so successfully in the natural world, which work against our best interests in the investment world, is the primary reason so many investors can become frustrated, confused, and disillusioned with investing. Unless we become familiar with, and learn how to control our ingrained natural responses, and substitute them with the right non-natural approaches, we’ll have problems. When using methods appropriate for success in a natural world, it is only natural to expect that we’d be incredibly frustrated, disillusioned and unsuccessful in the non-natural investment world.

How Your Brain Manages Risk

Let’s take some time becoming more familiar with the ingrained, natural-world risk and threat management hardwiring of our own remarkable brains and bodies. Once that is accomplished, we’ll review how to recognize those deep-rooted reactions that can work against us in the world of investments, how to manage them, and even how use them to our benefit.

Since we will be reviewing this subject at a relatively high level and rather quickly as well, I encourage you to seek out one of the best comprehensive sources on the subject of brain science as it relates to emotions, memory, fear, anxiety, and risk response. The books of Dr. Joseph LeDoux are outstanding. They include Synaptic Self and The Emotional Brain. As a university professor, and member of the Center for Neural Science and Department of Psychology at NYU, his books provide valuable additional insights in helping you better appreciate, understand, and manage your own magnificent brain.

Our brain’s risk management and response system, sometimes called the fear system, is prepared for dealing with threats in two ways. Of course, we are hard-wired and preprogrammed in the womb with instinctive responses to some threats. In addition and throughout our lives we’re also able to learn about new or different threats and then adapt to them by incorporating that new learned threat information into our fear and risk response system as illustrated in Figure 6.1.

Of course, risk management is a very broad and necessary ability in the natural world. That world strongly favors those species that can successfully manage the risks they face, because those species that are less successful risk managers just don’t survive. Therefore the brain is preprogrammed to respond to dangers that can routinely occur in the life of a species, and fear/anxiety is the natural involuntary reaction to those real or potential dangers. Some of the potential threats that can activate our instinctive threat responses are falling; spiders; snakes; surprising loud noises; and facing people, places or things we’ve never seen before. In addition, our brains are so flexible, that we can even learn to fear potential threats like poisons, high voltage power lines, terrorists, and other potential hazards that are not part of our instinctive hard wiring. Our brains are so programmed to help us prepare for risks that after exposure to a danger our brains can also learn to fear elements of the environment (the context) in which the danger occurred. This phenomenon is called fear conditioning, and it is so powerful that once an animal is conditioned, the context itself can generate the same kind of fear reactions as the actual danger.

FIGURE 6.1 The Fear System Overview

Source: From Joseph LeDoux, The Synaptic Self (New York: Viking, 2002). Used by permission of Viking Penguin, a division of Penguin Group (USA) Inc.

Over many decades of study, behavioral science has identified many other species that share very similar risk/threat management reactions with humans. These animals include fruit flies, marine snails, lizards, pigeons, rats, cats, dogs, monkeys, and baboons. All these creatures share the same high-level, risk/threat response behavior diagramed in Figure 6.2.

You may even recall experiencing “freeze, flight, fight” yourself or seeing it in others. It sometimes also occurs among investors experiencing volatile market drops or surprise negative news about their investments. In general, when animals or people sense a potential threat but do not have enough information to effectively assess whether it’s an actual threat or not, they will freeze and remain totally motionless, minimizing the chance of being noticed. This strategy of freezing also gives the animal time to assess the risk, while not drawing attention to itself. Depending on the nature of the possible threat, the animal may decide to ignore, confront, or flee, once an accurate assessment has been made. Since predatory animals are hardwired to detect motion, many times freezing by a prey animal will make it more difficult for a predator to detect it and thereby allow the risk to pass.

FIGURE 6.2 Preprogrammed Threat/Risk Responses

Although frozen and apparently idle from an external view, the innate risk management system of an animal in this state of aroused attention is far from idle. The threat response center of the brain is absorbed with enhancing and focusing the animal’s senses on the potential threat, increasing its heart rate, blood pressure, and respirations rate, and beginning to release stress response hormones, which will improve its physical abilities. The flight option of running away as fast as possible is used by potential prey in those situations where they know they have been detected, the potential threat is real, and attack is imminent. In these situations energizing hormones are dumped into their blood stream, all body systems are ramped up to maximum, and the animal is running for its life. The same response will sometimes activate in people of even average size at accident scenes. In those situations, some people have been known to somehow gain the strength to lift cars off of loved ones who were pinned underneath the wreckage. Fighting is the final alternative and last resort, when no other options are left. In the wild, fighting is the last resort strategy because it carries with it the very real risk of serious injury that may not immediately be fatal, but can lead to eventual death from infection, disability, loss of defensive abilities, and/or starvation, even for the winner of a fight.

The key to understanding what is happening inside the brain when the threat/risk response is activated is to understand the workings of one of he oldest parts of our brain, the limbic system. It is such an ancient part of the brain that it is sometimes referred to as the reptile brain. The limbic system structures are located in the center of the brain and are responsible for our body’s emotion and threat response systems. The seven principal parts of the limbic system are:

1. Amygdala

2. Cingulate gyrus

3. Fornix

4. Hippocampus

5. Sensory cortex

6. Mamillary bodies

7. Thalamus

This risk/threat management center of our brain is the master controller of our threat survival. It manages our body’s threat response including our split-second decisions to freeze, fight, or run away and escape dangerous situations. It also helps us remember the details of situations that generate strong emotions. Figure 6.3 illustrates the location of the hippocampus and the amygdala (Greek for almond). The amygdalae are the two almond-shaped organs situated next to the ends of the hippocampus. The other risk center structures, not shown in this illustration, are packed directly around the structures shown.

FIGURE 6.3 The Amygdala and Hippocampus Location

The amygdala controls our emotions, including love, affection, friendship, the expression of mood, mainly fear, rage, and aggression. Each amygdala contains over 20 functional areas and is also linked to brain parts that govern senses, muscles, and hormone secretion. We know the amygdalae have a controlling role and a great deal of influence on other brain structures because there are many more neurons running to those other structures from the amygdala than those same structures have running to the amygdala. The hippocampus is directly involved with memory and specifically with the formation of long-term memory. Scientific studies have demonstrated that the hippocampus allows animals to compare the conditions of a present potential threat with similar past experiences. This context memory enables an animal to benefit from its previous similar experience(s) and choose the best option to maximize its survival in a similar future situation.

We are fortunate to live in an age when our knowledge of the brain is increasing enormously thanks to the technological advances in brain imaging technology, and the hard work of dedicated scientists. As a result we understand more than ever before about brain function as well as how and where risk management takes place in the brain. In addition to its many other benefits, that knowledge will help you better understand and manage the risks you’ll face when investing.

Figure 6.4 reviews the steps of one of the hard-wired pathways our brains have developed to respond to risks, threats, and dangers that we see. Similar but slightly different pathways are followed with dangers/risks we identify through our other senses. The phenomenon of strong emotions taking over our physical actions is sometimes called hijacking the amygdala,

FIGURE 6.4 Hijacking the Amygdala

Source: Courtesy of Patricia Freedman and Joshua Freeman, Six Seconds (www.6seconds.org). Used with permission.

Figure 6.4 helps explain how visual signals lead to risk responses in the body.

Step 1. The eyes see the exclamation point (representing a possible threat the eyes detect) and convert it into a signal which is routed to . . .

Step 2. The thalamus, which analyses the signal to determine if it is a potential danger or not (and acting like an air traffic controller) then routes the signal to the right place in the brain for processing, in this case . . .

Step 3. The visual cortex then “thinks” about the impulse and determines if it is something the body should get excited about or not. In this case it thinks, “This exclamation point looks dangerous . . . my body should get excited.” The visual cortex then sends that danger signal to . . .

Step 4. The amygdale, which on receiving the threatening stimulus activates its lateral nucleus, which begins a cascade of emotional and defensive reactions and actions throughout the entire body.

In summary, the thalamus is the “air traffic controller’ for the signals coming into the brain from all the various senses. The sensory cortex (vision, smell, sound, touch, taste) initially interprets incoming signals as to whether they are either benign or threatening, and then if determined to be threats (or even potential threats) it alerts the amygdala. Once a threat alert is received by the amygdala (the emotional sentinel of the brain), it immediately stimulates numerous internal systems to insure that the body is emotionally and physically ready to do what is necessary to defend itself.

The Long and Short of It

Brain and behavioral scientists have now learned that information from external stimuli travel to the amygdala along two different pathways inside the brain, not just one. The short pathway is a very fast and nonspecific connection directly from the sensory thalamus to the amygdala. The long pathway runs from the sensory thalamus to the sensory cortex, looping in the hippocampus, before finally reaching the amygdala. Although this longer route is significantly slower, it is also more precise. In essence the shorter, more direct route provides an almost instantaneous response to a possible threat, allowing us to start preparing for it even before we know what it is. If, when the slower more detailed signal arrives at the amygdala with the sensory cortex’s analysis and the hippocampus’s context, and it confirms a danger, a significant time advantage has been gained. However, should the slower more information-filled rich signal arrive at the amygdala later and identify the perceived threat as a false alarm, that’s even better. Particularly in high-risk or life and death situations, that speedier reaction time of the short route, even with the risk of reacting to a false alarm, is a big advantage over taking more time and being more certain before reacting to a potential threat. Figure 6.5 provides a simplified illustration of difference between the long and short fear pathways in the brain.

FIGURE 6.5 The Brain’s Long and Short Fear Pathways

Source: Adapted from Joseph LeDoux, The Synaptic Self (New York: Viking, 2002). Used by permission of Viking Penguin, a division of Penguin Group (USA) Inc.

Get to Know Your Second Brain

Have you ever experienced a tense, upset, cramping stomach; stomach butterflies; a tight throat; or a strong intestinal urge before or during a stressful situation like an important job interview, presentation, a speech to a large group, an important test, or when investment prices move the wrong way? If so, you’re certainly not alone. In fact, all those experiences and more are very common results of the extremely long and close relationship between our body’s two essential brains. Those uncomfortable feelings are the result of your normally quiet and remarkably efficient second brain letting you know it’s on the job. Of course, you are no doubt very familiar with the brain in your head. However, you may not be as familiar with your other brain, the very important but hidden brain in your gut, known as the enteric nervous system or ENS.

Now you may be asking yourself, what does this second brain in my belly have to do with investing and risk management? The principal reason we’re reviewing it is the same reason why we’ve already discussed the human risk management process, the history of risk management, the two basic schools of risk management, and how our first brain deals with risk and threats. Quite simply, the more we know and understand about risk, our reactions to risks/threats, risk management, and the better prepared we are, the better risk managers and the more successful investors we’ll become. Since the enteric nervous system can also generate physical manifestations in our bodies when we’re facing threats, risk, or stressful situations, it is imperative that we also understand as much as we can about it as well.

Professor Michael Gershon, M.D., Chairman of the Department of Anatomy and Cell Biology at Columbia University Medical Center, a true expert on the ENS, coined the term second brain to describe this nervous system. Although the ENS sheaths the tissues lining the full length of the entire gut from the esophagus, stomach, and small intestine to the colon, it is considered one entity. The enteric brain neuron network sends messages back and forth along its length, allowing it to perform all its numerous, necessary, and complex functions and to learn, remember, generate gut feelings, and operate independently. This powerful second brain has over 100 million neurons (more than the spinal cord), and its only direct connection with the central nervous system and the brain is through the vagus nerve.

The nerves of the second brain were the very first nerves to develop in the bodies of primitive tubular animals hundreds of millions of years ago. Those early enteric nerves gave those first primitive animals a survival advantage in more efficient management of their food digestion. As animals evolved further the central nervous system developed in response to the need for additional brainpower for finding food and mates and for surviving. Over time the central nervous system and enteric nervous system developed connections, but the enteric system maintained its independence. Scientists believe that the earlier development of the gut brain, combined with the enormous complexity of efficiently digesting and excreting food material, plus the benefits of locating the control of digestive processes as close to the actual process as possible, are the reasons that the second brain has maintained its relative autonomy. Even so, both brains have a great deal in common, including the fact that very early in our embryonic development the brain in our head and the one in our gut both originate in the same embryonic neural crest tissue, then separate and migrate to their designated locations as embryogenesis progresses. The role the enteric nervous system plays in risk management is very interesting and one of its primary purposes.

To view a color illustration of “The Brain in Our Gut” visit:http://www.nytimes.com/imagepages / 2005 / 08 / 22 / science /20050823_GUT_GRAPHIC .html

Applying This Knowledge

All these findings about our natural and ingrained threat response systems help to explain the uncomfortable physical phenomenon many investors experience during major market drops. When humans’ internal risk management systems sense a threat or danger, a full complement of emotional reactions (including fear, dread, and anxiety) and physical reactions (increased acuity of the senses, laser focus on the threat, increased heart and breathing rate, elevated blood pressure, sleeplessness, queasy stomachs, tense muscles, tension headaches, distrust, isolation, and threat hormone release) are rapidly generated to deal with the threat. As a result, these strong, automatic reflexive risk responses can activate investors’ freeze, flight, and fight response and easily override or hijack their logical thinking as well. Of course, two, three, or more of these conditions occurring simultaneously can be very unsettling, because all the body’s highly developed survival instincts are kicking in and fully energizing it to freeze, flee or fight a possible natural-world threat. You feel compelled to act, to comply with what you body is telling you to do, because not only does it feel like the right thing to do, but also taking action is the only thing you can do to neutralize the risk management urgings generated by your body.

This happens in all potential threat situations because our brain isn’t hardwired to discriminate between a real-world natural risk and a non-natural-world risk. It reacts the same to both. That’s why it’s so important to get to know, understand, and be able to identify our body’s ingrained and natural risk management responses when they occur. You can then apply that knowledge by letting those natural responses run their course in dangerous natural-world situations, while controlling them by putting them in context when the occasional non-natural risk (like a big, and always temporary, market drop) occurs.

In a potentially dangerous situation, if you don’t understand that what is happening to you is a normal and natural reaction to a potential natural-world threat, or if you don’t know the importance of discriminating between a natural threat and a non-natural threat, then you can easily fall victim to a very common and costly investment pitfall, when your animal brain overcomes your logical brain. A natural risk like a fire in your house, and a non-natural threat, like a stock market drop when you are in your thirties are very different risks requiring very different responses.

Once you gain knowledge, comfort, experience, and then confidence in your practical application of this knowledge, you can even use those tangible threat response manifestations to your advantage as confirmation of potentially very attractive, non-natural investment world opportunities.

CHAPTER 7

Understanding the Risk Perception/Reality Gap

Three-fourths of the mistakes a man makes are made because he does not really know the things he thinks he knows.

James Bryce

Risk assessment is one of the foundations of effective risk management, and a cornerstone of risk assessment is an accurate and realistic understanding of the nature of the risks to be managed. It is so important because inaccuracies in understanding the nature and characteristics of any risk at the very beginning of our risk management process will lead directly to problems in effectively managing those risks. It’s very much like the old “GIGO” axiom about computers, “garbage in equals garbage out.” The better the quality of your basic input data, observations, or assumptions, the better the quality of your end results. If the basic information you start with is flawed or inaccurate in some way, how can you expect an accurate end result? Why even waste time going through the full exercise without first finding out whether the basic information you’re starting with is accurate?

Our big challenge is that humans share a common and curious tendency to perceive risks very differently from reality, because our emotions and various experiences can impact the process so heavily. There are certainly risks that we perceive accurately. However, there are many risks that we perceive to be greater than they actually are (sometimes much greater), as well as an abundance of risks we perceive to be less then they actually are (sometimes much less). Quite simply, not understanding this very common risk/reality gap and not compensating for it can create some problems in effectively managing risk. The more accurate your understanding of the true nature and characteristics of a risk, and the smaller your risk perception/reality gaps, the better decisions you’ll make in managing risk. The corollary is also true, in that the wider the gap between your perceived assessment of a risk and the true nature of that risk, the greater potential damage you’re likely to suffer should that risk occur. That’s why it’s so extremely important to understand this common risk perception danger, so that you can minimize your perception/reality gaps when it comes to risk management.

Unfortunately for human beings, understanding and controlling the possibility of risk perception and risk reality gaps is much easier said than done. That’s the case because risk perception is very much a case-by-case individual matter that can differ widely from person to person, based on a range of variables. There are no general answers. Each one of us has to honestly evaluate and the address our own strengths, weaknesses, and potential risks in this area. Since understanding and accepting that a potential problem exists is the first step in addressing it, the purpose of this chapter is to help you become more aware of and better understand risk perception/reality gaps, and then review how to minimize them in your investment risk management efforts.

How We Perceive Risks

Behaviorial scientists have documented that humans very frequently overestimate or underestimate the risks we face. We do so both individually and as groups, and it can have serious negative side effects, which could have been avoided. Although risk perception is an individual, person-by-person matter, behavioral scientists have discovered a few common denominators. Those commonalities can provide clues to the way humans determine, on a subliminal level, what we should fear and how fearful to be when we confront those risks. Outlined below are some behavioral science findings about common risk perceptions as presented by authors David Ropeik and George Grey in their 2002 book: Risk!—A Practical Guide to What’s Really Safe and What’s Really Dangerous in the World Around You. In addition, I have included my own observations of common risk perceptions in the investment world. Although it’s helpful to keep in mind that these are generalizations about most people, it is very interesting that these common risk perceptions/misperceptions are so widespread. They occur all over the world, throughout all cultures and age levels, and among both men and women. It is surely an indication of how these common perceptions must have provided our ancient progenitors with some significant survival advantages and have therefore been hard-wired by natural selection into the common risk management behaviors we all share today.

Common Widespread Risk Perceptions and Misperceptions

Generally, people have numerous ingrained risk perceptions and misperceptions. They include the following:

• Being more afraid of risks that are new than risks that have been lived with for a while. (Concerns about a potential nuclear war in the 1950s created a nationwide mania in building personal backyard bomb shelters. While today the world’s combined nuclear bomb destructive power dwarfs what it was in the 1950s, we are much less anxious about the threat, even though its potential impact is much bigger, because we have lived with it so long.)

• Being less afraid of risks that are natural than those that are human made (People tend to be much more fearful of exposure to radiation from their microwave oven or high voltage electrical wires, yet they take a much greater and documented risk by laying out in the sun’s radiation at the beach for pleasure.)

• Being less afraid of risk they choose to take than those that are imposed on them (like skydiving or scuba diving versus having to have major surgery).

• Being less afraid of risks that also confer some benefits they want. (Millions of people live in the southeastern and gulf seacoasts of the United States in the direct paths of devastating hurricanes, which occur every summer and fall, because they like the warm winter and spring weather.)

• Being more afraid of risks that can kill them in particularly awful ways (like being accidentally pulled into a wood chipper, crushed to death or decapitated, instead of being afraid of succumbing to the leading cause of death in the United States, heart disease).

• Being less afraid of risks they feel they have some control over (like driving a car versus being a passenger in a commercial airliner, when large commercial aircraft have proven to be one of the very safest form of transportation).

• Being less afraid of risk that come from sources they trust (places, people, organizations) such as hospitals, doctors, members of clergy, pharmacists versus chemical companies, weapons manufacturers, or nuclear power plants.

• Being more afraid of risks they are aware of (like terrorism after 9/11).

• Being less afraid of risks they are less aware of (like terrorism before 9/11).

• Being much more afraid of risks when uncertainty is high (such as just after a series of major stock market drops).

• Being less afraid when they know more (like following a series of consistent stock market advances).

• Parents are more afraid of risks to their children than to themselves.

• Parents are more afraid of potential toxins in their children’s schools than in their own homes.

• Being generally more afraid of risks that can directly affect you than of a risk that threatens others.

• Disasters that affect people in a different part of the country are considered interesting news, while disasters that effect us personally are tragedies.

• Being less afraid of risks in investments and markets that have been rising in price. (Investors world-wide threw caution to the wind and saw little or no risk in the Internet bubble of the late 1990s and the real estate bubble that topped in 2006.)

• Being more afraid of risks in investments and markets that have been falling in price. (Many investors actually cashed out and/or then totally avoided investing in the stock market crashes of 1962, 1970, 1974, 1982, 1987, 1990, 1998, 2003, and 2008, all of which through 2003 eventually recovered to set new highs.)

In summary, because of our ingrained predilections, we often underestimate the actual risk in situations where we have personal control, that are known and familiar to us, are totally voluntary, are associated with a reliable and trustworthy source, and are natural. The opposite occurs, and we regularly overestimate the risks in circumstances that are unknown or we’ve never faced before, involuntary, not in our control, associated with an unreliable or untrustworthy source, or are man-made.

Of course, there are exceptions to these very common risk perception generalizations. These exceptions occur because we all have different experiences, upbringing, personalities, and confidence levels in the different threat situations we face. Our individual differences can either reduce or increase our particular fear level in various circumstances. These variations in individual fear levels are neither a negative nor a positive, they are just simply differences in our individual perspectives and feelings. The real problems come from the fact that we rely very heavily on our feelings in our daily decision making, leading us to sometimes trust those feelings too much when evaluating threats and risk. Our perceptions of and responses to threats, risks, and rewards are very powerful drivers of our behavior, thoughts, and emotions. Should those critical initial risk perceptions be wrong, they will compromise our risk taking judgment and lead to potentially very far-reaching and serious implications. The good news is that through greater awareness, knowledge, understanding, and preparation we can manage those risks and the factors that influence them. We can minimize future risk misperceptions, improve our risk management effectiveness, and become more successful “Risk-Wise” investors.

FIGURE 7.1 Innate Common Risk Perceptions vs. Risk Reality

Fluctuating Perceptions

One of the other facts behavioral scientists have discovered, other than the widespread and common risk perceptions we just reviewed, is that our risk perceptions are always fluctuating. Those fluctuating perceptions make our individual and group anxiety and fear levels cycle both up and down over time. The stock market is a perfect example of the kinds of swings we can observe from the peaks of joyful euphoria to the depths of utter despair. The graphic examples in Figures 7.1 to 7.4 illustrate the relationship between risk perception and risk reality. As you review the illustrations, please keep in mind that they are simplified for the purpose of easier visualization of the concepts and relationships presented. Even the real risk visuals depicted in the following figures are not as fixed and unchanging as they may appear in the illustrations. Actual risks can vary over time and from person to person, based on each person’s particular knowledge of, comfort with, and preparation for dealing with a risk.

Figure 7.1 illustrates how risk reality for a range of risks remains unchanged while the perception of innate higher perceived risks fluctuates slightly higher than reality over time, and the perception of lower perceived risks fluctuates slightly lower than actual risk over time. (Note that both the innate lower and higher perceived risks never fluctuate to match reality.)

Figure 7.2 shows how experience-based, everyday risk perception (which can be altered by knowledge, experience, and risk exposure) fluctuates over time. (Notice that even though these everyday risk perceptions fluctuate over time, they rarely move to extremes.) They can move from being lower, equal to, and even higher than the actual risk, right back to lower than real risk again, based on the changing nature of risk and a range of personal factors that can influence risk perception, including new exposure to the risk.

FIGURE 7.2 Mild, Experience-Based Risk Perceptions

FIGURE 7.3 Extreme Risk Perception Fluctuations

Figure 7.3 depicts a form of risk perception characterized by very big swings and extreme variations in risk perceptions, situations where one moment the perceived risk is low to moderate and the next moment the perceived risk becomes enormous. These wide swings in risk perception are typically generated in activities, settings, or environments that are exposed to one or more of the four emotionally charged situations where perceived risk can become enormous. These situations include the following four:

1. Where there are large-scale consequences to a risk

2. Where the risk is new, unfamiliar, or not understood

3. Where the risk is beyond our perceived control

4. Where the risk occurs suddenly and is unexpected

Can you think of any real-life situations that fit one or more of the risk perception-multiplying factors we have just reviewed? How about tornadoes, tsunamis, flash floods, landslides, earthquakes, natural gas explosions, terrorist attacks, accidents, and one example very close to the core subject of this book and familiar to experienced investors everywhere, the securities markets when major market collapses occur.

Granted, the time frames can be long between extremes, but one of the hallmarks of liquid securities markets for centuries is the fact that they are well known for moving from oversold and undervalued extremes at one end of their cycles to overbought and overvalued extremes at the other end of the cycle.

User-Friendly Risk Management

What Is a “Risk-Wise” Investor?

The Holy Grail?

The Game Has Shifted

The New Way to Gain Mastery

Release Your Own Natural, Everyday Risk Management Power

Releasing Your Natural, Everyday Risk Management Skills

The Everyday Life-Risk Risk Management Process Steps

Releasing Your Everyday Life-Risk Management Skills in the Investment World

The Fundament Principals of “Risk-Wise”Investing

Building a Solid Foundation

The “Risk-Wise” Investor—Risk Management Process Steps

The “Risk-Wise” Investor Process

Historical Highlights

Part 1: The Ancient Past (Pre-600 B.C.)

Early History (600 B.C.-A.D. 500)

The Middle Ages (A.D. 500-A.D. 1500)

Part 2: The Renaissance

Part 3: Entry into the Modern Age and Up to the Present

Observations from the History of Risk and Risk Management

Your Definition of Risk Is Crucial

The Many Meanings of Risk

Treat the Cause Not the Symptom

An Empowering Definition of Risk

Understanding the True Nature of Risk

The States of Risk

What Is Risk Management?

The Big Question

Quantitative versus Subjective

Trust the Numbers?

Basic Assumptions Behind the Quantitative Risk Management Approach

Strengths of the Quantitative Approach

Investment Reality

Sample of Weaknesses in the Quantitative Risk Management Approach

Quantitative Risk Management Approach Summary

Trust Your Gut?

Basic Assumptions Behind the Qualitative Risk Management Approach

Strengths of the Qualitative/Subjective Approach

Investment Reality

Sample Weaknesses of the Qualitative/Subjective Approach

Qualitative Risk Management Approach Summary

Two Is Often Better than One

Both Beast and Human

Model T Biology in the Internet Age

Understand the Enemy Within

The Non-Natural World of Investing

How Your Brain Manages Risk

The Long and Short of It

Get to Know Your Second Brain

Applying This Knowledge

How We Perceive Risks

Common Widespread Risk Perceptions and Misperceptions

Fluctuating Perceptions

Upside-Down Perceptions

Outrage and Risk

Final Thoughts

Decision-Making Patterns and Biases

A Lesson about Ourselves

Pattern Finding in Randomness

Recognizing Real Randomness

Mental Magnets

Luck, Smarts, or Both

Following the Herd

The Greater Fool

Trees Growing to the Sky

Common Hidden Traps

Guarding Against Decision-Making Traps

Managing Specific Portfolio Risks

Common Risks of Equity (Stock) Investing

Common Risk Management Strategies for Equity Portfolios

Some Common Risks of Balanced (Stock and Bond Portfolios) Portfolios

Common Portfolio Level Risk Management Strategies

Making the Job Easier

Risks You Can Avoid Completely

Internal Risks You Can Avoid

Risks You Can’t Avoid But Can Manage

Risks You Can’t Avoid and Can’t Control

Risks and Rewards You Knowingly Seek and Can Control

A Closer Look at Crisis Events

Simple Is Better

Brief History of Passenger Airlines¹