Risk averse or Risk blind?
Hitting the sweet spot in risk
Hi.
Reading time: About 5 minutes
Today’s post is me penning down some thoughts on risk. Risk is a very interesting topic to write about. In India based on all the experiences I have had we are a very risk averse country. We prefer to buy houses due to security, in the west there is a culture of renting the living space. So I find it very interesting as to how one should think about risk.
This is a very simple chart. Prof. Bakshi had drawn this in his behavioural economics class.
Risk blindness
Off the back of my head when I think of risk blindness I think of things like Formula 1, stuntmen, a lot of red bull videos, etc. There are countless people who live off the adrenaline of living life on the edge. Everyone knows the risks that are involved. There are many incidents where there have been deaths in doing these dangerously risky activities.
“What are the eventual consequences of risk seeking behavior? That is, if you persist with behavior that’s risky, then what will happen to you?
In my view, the answer to that important question is provided by one of the principles of probability. And it’s a principle which all of you studied in high school. That pr inciple states that probability of one occurrence of a rare event, if you increase the number of trials tends to become 1. That is, if you keep jumping out of planes with parachutes which fail to open just 1% of the time, you will eventually get killed.” - Prof Sanjay Bakshi
The question I ask myself and still a little confused about is why do people take such risks?
It is different for every person but there is one thing. More often than not people take such risks for more than one reason.
Let’s turn to our mental models,
When someone does something like becoming a serial bank robber. (let’s assume it is being done because they are tired of living a miserable life). They risk what they have and need to get something they want but do not need. That’s the important thing here. I am saying there is no need it is a want.
The person robbing the bank very well would know that it is a high risk activity. Then why do that again and again. I can think of a few reasons :
Overconfidence: Successfully robbing a bank once could mean that the robber is very confident in his ability of getting away with the crime. Everyone overestimates their ability and always thinks that it is their skill that is making them successful but they never consider the fact that it could just be luck.
Envy: As Munger’s famous saying goes the world is driven by envy and not greed. I am certain that most robbers are envious of others and that is why they feel the need to rob.
There are definitely more mental models which could apply but I apologise I could not take the time to write more about them.
If you think about investing or business there are many cases where people have risked what they have and need to get something they don’t need.
The most famous example is that of LTCM. Even the example of Ivar Krueger where we saw how he just kept doing wrong things and taking more risk even though he had a legit business.
So it is not uncommon that people do this. People very often are risk blind. There is no single reason.
Risk aversion
So what about doing the opposite of risk blindness and not take any risks. Not taking risk would save us from the downsides right? If I don’t invest in businesses and invest in a FD my money would be safe and the chances of losing the money are close to zero. So why not put money in an FD. Another example could be there are a lot of accidents on the road that occur, so the best option would be to not drive right? I would be better off going in someone else’s car who is an expert driver.
Not taking any risk is one of the biggest risks. I am pretty sure this is a quote from somewhere.
Imagine any sport also, if you don’t take a risk with certain shots you would never succeed. If I played basketball and never shot from outside the 3 point line I would never have a 3 pointer in my life. If I played football and never trusted my ability to score and took the shot I would never have a goal. If I played cricket and never hit an attacking shot I would never have a six or four which was intentional.
Not taking any risk is a sure shot way to be mediocre in my opinion.
Sweet Spot
So what to do?
If not taking any risk is risky, and taking to much risk is also a problem what should one do.
One thing is for sure. You have to make risk your friend. I believe you have to find a balance.
If I am batting and my team is in a bad situation then I have to reduce the risk I take. Similar to investing, if you have a lot of capital and you have to preserve you have to look for businesses where you are rest assured that you will not go bankrupt. You have to look for bets where you don’t lose in a way where you are wiped out.
Buffett has so much capital that I think he is very right on his risk aversion,
“I would rather be, you know, a hundred times too cautious than 1 percent too incautious, and that will continue as long as I’m around.” Warren Buffett
These are three rules of Prof. Bakshi,
In conclusion, I would like to list the three “no fault” rules I talked about:
No Fault Rule # 1: Stay Away from Leverage
No Fault Rule # 2: Seek Protection from Nature
No Fault Rule # 3: Be Wary of Promotions
Following these rules has helped me avoid horrendous and permanent capital losses. I hope that you’ll find them useful.
Resource:
Thank you for reading,
Samvit.