Three sides of Risk

Hello All

Came across this interesting article by Morgan Housel; thought it will resonate with this group

For those who don’t know, Morgan Housel is the author of ‘Psychology of Money’ - a brilliant book!

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There are more sides to risk. Or rather, it is not possible to prepare for “risk” if we are not picturing it as “risk of”. Those risks of can be assessed together to get a broader picture of the “risks” you are exposed to, but this picture ever only includes the phenomenons you have taken into account, which is very important to remember.

Regarding tail end events, in natural hazards handling, they are on the backburner but don’t take on most of the bandwidth. They are not “all that matter”. They are dealt with passively, by having a setup (here an investing strategy) that allows for the best mitigation of their impact that can be. That mostly passive setup includes checks for when the probability of the risk materializing increases as well as measures to take when those checks are reached. Then, the risk situation is dealt with actively by following the plan before the event (which is also one of the hardest part when dealing with natural events: some people will always think they know better and things should be done differently) and actively managing them with the means we have made available beforehand after the risk has materialized.

In investing, I tend to think that our family, friends and general skillset are our best line of defense against tail risk. Of course, that doesn’t give us a free pass to ride the markets carelessly and our strategy should still limit our exposure to those if it can reasonably be done, so IPS (investment policy statement (link to the Bogleheads’ page on it)) matters a lot too.

I also find it important to be mentally prepared for tail risk to show up. What would I do if I were to loose it all? Plenty of people survive on minimal amounts of social security, it isn’t something unfathomable that "if we get there, we’ll have bigger problems to worry about (a phrase I have issues with because, well, yes, which brings the question “why are you not at least remotely preparing for dealing with those bigger problems?”). Being destitute may become part of my life, I want to give myself the best chances of bouncing back that I can reasonably afford if that happens.

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Thanks for your thoughtful response @Wolverine

I am in the process of writing my own IPS right now, and this is valuable feedback.

Hmm. What I find interesting in these many similar posts of you is that you consider that a catastrophe may happen because you did something wrong (“I am destitute”). This seems to be what you are thinking about when you are thinking about very low probability risks. When I think about such things, I picture events at the level of global nuclear war, i.e. a catastrophe may happen but I can’t realistically prevent it (too late to become POTUS or even a Bundesrat). Anything short of this I consider a normal part of life and manageable. Granted, I am married and my wife is working, so I am not the only bread earner for the family. Still it is interesting to see what we consider to be a tail risk.

I had thought about the formulation for the “I am destitute” part and didn’t find one that properly reflected my meaning, the purpose was to separate the situation (what I live) from who I am, which seems to be the opposite of what you seem to have understood it to mean. What I meant was that no matter what protections I take, at some point, I might have to live with no/few money and I want to be prepared for that.

You are right that I am very big on the concept of responsibility, but I don’t think we are necessarily responsible for what befalls us. What we are responsible for is how prepared we were to deal with it (which includes mental preparation, which, for many events, is enough) and what we do when confronted with the situation.

In a buy and hold financial strategy, tail risk could be markets falling for 40 years and not recovering. I can’t prevent that and am not responsible for that but if I put my wealth 100% into stocks with the idea that they’d only go up, and then fail to reach my financial goals as a result of it, then my preparation was less than adequate and there are steps I could have taken to avoid the unpleasant to dire situation I am living.

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my question would be why it resonates with you, @EverydayJedi ?

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Yes, people tend to think that the historical equity premium is a human right going forward. I’m not so sure about that, as I’m not convinced of the myth of eternal growth. But so far, I’m willing to take the risk…

However, I’m planning to diversify with a global variety of government bonds and a variety of commodities. Regarding the latter, I really don’t see how people think owning wheat or steel is riskier than stocks.