This is a big problem with the finance and investment industry. After a catastrophic event like 2008, everyone (especially people who were there in 2008) are just constantly focused on risk. Every single professional tells you “focus on risk, manage your risk, risk management is the key to success”. And herein lies the main problem for experienced traders and investors.
Yes, focusing on risk is good. A lack of risk management is how people make 40% for 4 years and then lose everything in the 5th year. That’s reckless. HOWEVER, EXCESSIVE focus on risk is detrimental because you kill the golden goose.
You see this all the time in the investment industry. Do you know why the average hedge fund nowadays can’t even beat buy and hold? Because everyone – including their clients – is so paranoid about risk. “HOLY SHIT YOU LOST 5% THIS MONTH?????? AHHHHH!!!! TIME TO TAKE MY MONEY OUTTTT!!!!” Everyone is so focused on micromanaging risk. They can’t endure any short term downside.
In essence, these professionals want stock-market-like returns with bond-market-like volatility. Outstanding returns with exceptionally low volatility.
That just doesn’t happen. The world doesn’t work that way, and any guru claiming that he can make a consistent 2-3%, month after month is just lying to you (that’s what Bernie Madoff did).
As a result, this excess emphasis on risk has resulted in PARANOIA among professionals and experienced traders. They start worrying about every little thing. Here’s just an example of things that professionals worry about within a span of 12 months:
- January: rising interest rates worry me
- February: political uncertainty worries me
- March: France worries me
- April: geopolitical problems in the South China sea and middle east worry me
- May: falling inflation worries me
- June: rising inflation worries me
- July: rising oil worries me
- August: a slight decrease in earnings growth worries me
- September: emerging market slowdown worries me
- October: the Fed’s monetary policy worries me
- November: slowing earnings growth worries me
- December: yield curve flattening worries me
Jeez. The “worry train” just never stops.
So stop focusing on risk. Stop “worrying”.
Instead, focus on the EXPECTED VALUE of risk. If all you do is focus on risk, you will end up paranoid and afraid that a meteor hits the earth tomorrow.
What is the “expected value of risk”
Expected value of risk = the magnitude of the risk * the probability that the risk will actually happen
The key here is the PROBABILITY component. Everyone knows what the magnitude is. “HOLY SHIT IT’S A TRADE WAR!!!! CATASTROPHIC!!!!!” What people don’t bother doing is calculating the expected probability of that risk actually happening.
Here’s a simple example. What’s worse?
- A 1% risk of a 30% crash, vs…
- A 10% risk of a 3% loss?
These 2 scenarios have a same EXPECTED VALUE of risk (-0.3%). If you trade using the 2 strategies over a long period of time, you would end up exactly the same.
Remember: blindly focusing on risk and not taking into account the PROBABILITY of each risk happening is detrimental to long term performance.
Think about risk management as an upside down parabola. Up to a certain point, increasing focus on risk is good for your long term performance. But past a certain point, increasing focus on risk is bad for your long term performance.
It’s worth mentioning that the “expected probability of risk” can’t be something you fabricate out of thin air. You see this all the time. “Goldman thinks there’s a 20% chance a trade war deal will happen”. This 20% is frivolous. It has no data to support it. They literally fabricated “20%” out of nothing, for the sake of appearing legit and scientific. You need data-driven evidence to support or refute a probability that you provide.
Here’s a non-trading way to think about the expected value of risk. Insurance companies and actuarians do this all the time.
Insurance companies, like investors and traders, need to calculate risk. But they don’t just look at all the possibilities equally and label them as “risk”. They don’t charge random premiums based on how big they think a risk “could” be.
Instead, they calculate the potential damage AND probability of each risk, such as a hurricane. Only then can they adequately understand the true nature of risk.