On Risk

On Risk

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My discussion of Nassim Taleb’s macrobullshit — his unfulfilled public warnings on interest rates and inflation in 2009 and 2010 — has made me ask some tough questions of my own mental framework for understanding risk. 

We live in a world where all of our actions and decisions are coloured by uncertainty — the gaps in our own knowledge, the uncertainty in the consequences of actions. This uncertainty creates risk that consequences won’t match intentions and desires — the risk of disappointment, the risk of losing money, the risk of looking foolish, the risk of unemployment, the risk of death, etc, etc. We take many kinds of risk whenever we act and whenever we do not act. Yet risk does not stem solely from our individual behaviours. There is also the uncertainty of the flow of events beyond our control.

Checking risk is the purpose of hedging. We compensate for perceived risk by adjusting our behaviour to make ourselves robust to risks, or able to benefit from them. An obese person may hedge the perceived risk of death and lack of physical fitness by losing weight and becoming fitter. We learn the skills we perceive necessary for our work to hedge the perceived risk of being incompetent and losing the job. We amass investments over our lifetimes to hedge against the worklessness of retirement.

Everything has an opportunity cost, and adjusting behaviour or systems to compensate for perceived risks — to make yourself robust or antifragile, as Taleb would put it — always has opportunity costs. One hour spent learning one skill is an hour not spent learning another skill. One hour reinforcing a house’s foundation against earthquakes is an hour not spent reinforcing a house’s roof against winds. To use the example that started my thought process, Taleb warned governments worldwide about the danger and fragility of excessive debt and deficits, and calling government debt a gigantic Ponzi scheme. The implication that governments should robustify by reducing deficits and debt was clear.

But debt and deficit reduction, of course, also has opportunity costs. It means the government must cut its budget, meaning less money for, for example, creating jobs for the unemployed. Unemployment was something that Keynesians argued was the greater threat, the more immediate fragility that needed tending to.

Of course, risk management and risk assessment is hugely important. You don’t want to be caught in a sword fight without a sword or an escape route.

So the problem that exists is prioritising which risks we should focus our efforts upon. And I do not think potential impact is the only matter at hand here. The potential impact to my livelihood and wellbeing of a grand piano falling through the roof of my house is massive, but do I worry about it? No — because it is both extremely unlikely, and if it did unexpectedly occur I wouldn’t be able to do anything about it. 

Instead, I consider the potential impact of a risk after I establish that it is a real risk that can cause damage. Then I consider whether I have the ability to take action to reduce or eliminate the risk, and then I consider the opportunity cost of action, weighing the cost of taking action against other potential actions.

Focusing on the likelihood of immediate damage prioritises immediate real world problems over imagined future problems that might — but also might not — cause damage in the long run. If you are fighting a bear that could kill you, the lion — or food poisoning, or freak weather — that might kill you in the long run is irrelevant.

As Keynes noted “…this long run is a misleading guide to current affairs. In the long run we are all dead.” 

That doesn’t mean that we should ignore the possibility of longer term risks, either. But it is easier for a patient with a long term condition like obesity or diabetes to improve their condition when he or she is not simultaneously suffering from a severe bout of the flu. Deal with the immediate risk. First things first.

And in a world where what we perceive as potential future risks may turn out to not be the real risks at all (e.g. German invasion of France over the Maginot line), where fighting imagined future risks comes with high opportunity costs or blowback, and where totally unexpected flows of events can conjure up massive unimagined shocks, crossing bridges as we come to them is sometimes the only option nature allows. 

Should, for example, we really expect central bankers — charged with maintaining low inflation and low unemployment — to go out of their way to try and burst supposed asset bubbles in the economy, given the opportunity costs and the risks of blowback and unexpected consequences, like causing a recession or depression via excessive tightening? I don’t think it’s realistic to do so, even if central bankers strongly suspect that a bubble exists. Bubbles burst, but these are bridges that we can only really cross when the market gets there (remember that central bank attempts to burst a bubble may be interpreted very differently by human actors in the market).

And we are built with innate capabilities that help us to cross bridges as we come to them. As humans we are capable of dynamically assessing and reassessing risks to reflect new information, to update our priors, and to filter out noise. This is not some post-hoc intellectual demand. It is something that we do inevitably. If a bear attacks, we instinctively, hormonally and instantaneously react to the problem at hand and drop our other problems.

Accepting that our risk management abilities are very limited, of course, means accepting the fact that we cannot always withstand or benefit from risks, and that sometimes trying to make ourselves more robust or antifragile to one risk can leave us exposed to another. That is life. It is all very well to encourage people to think about how not be a proverbial turkey — the fattening bird, happily extrapolating from past trends and expecting to be fed every day, up until Thanksgiving, when the turkey is killed and butchered. But how can a turkey really avoid being a turkey? Maybe some adventurous turkeys destined for the butcher’s knife will escape from the farm. But there are irresistible forces in this world. As Keynes said, “in the long run we’re all dead”.

Sometimes people are caught in a sword fight without a sword. And that is life.


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