Risk and Uncertainty

Risk Ignorance and UncertaintyI have been reading about risk and uncertainty in my hotel room in the US even as more than 30 tornadoes lash out in and around the central part of the US. The Weather Channel has been playing on and off throughout the day on my idiot box. Now yesterday, there was uncertainty around the exact location of these twisters which is now gone as the images of collateral damage and the swirling debris comes out from the north east of Oklahoma City. From the perspective of the residents of this area, there was (and actually still is even as I type) a risk of serious injury to life and limb. As the messages on the Weather Channel keep on advising, that risk can be minimised by heading down to the lowest level of your house (preferably a brick/stone/concrete structure and keeping one’s curious eyes away from the glass windows. That is risk and uncertainty. Well, almost!

The major difference between risk and uncertainty is that uncertainty is the lack of faith in a situation while risk is to put yourself in that uncertain situation. Risk can be measured and therefore probabilities can be calculated. With finite probabilities in place, strategies can be devised to minimize them – in the world of investing these would be hedging, collateral posting, diversification etc. When airplanes were introduced, people would have been scared to fly due to the risk involved and they surely must have been right. However, with technological advances that risk has greatly come down. Initially, when the first automobiles ran the streets of London, the Locomotive Act of 1865 sought to control the severe risks of running the iron horse carriages on the streets:

  1. Speed limit of 4 mph on country roads and 2 mph on city roads!
  2. Each beast must have a crew of three – the driver, the stoker and the red flag man.
  3. The red flag man should carry the pennant and walk 60 yards ahead of the vehicle warning people to get out of its way.

So there was risk and it was being minimized. Further, as the harnessing of steam became more efficient, the risk reduced and the law changed accordingly: in 1878 via the Highway and Locomotive Act which reduced the offset of the red flag man to 20 yards. Obviously, the railway and horse carriage lobbies were at play but their arguments must have been eventually blunted by the fledgling auto industry’s demonstration of risk control. Finally, in 1896, the new Locomotives on Highways Act made the following allowances to vehicles less than 3 tons in weight:

  1. speed limit of 14 mph
  2. no need to have the three member crew including the need to have the red flag man announce the arrival of the vehicle.

Finally, in 1903, the speed limits were further increased to 20 mph and then the law was eventually repealed.

To measure and thereafter control risk, the presence of historical data is required to assign probabilities to various outcomes and construct a probability distribution of the known outcomes. Uncertainty exists when the decision maker has no historical basis from which to develop a probability distribution and must make intelligent guesses to develop a subjective assessment of outcomes and their likelihood. So many folks confuse risk and uncertainty and use them interchangeably. Let me take a topical example to bring out an example of how most people confuse the two terms. Let’s say an insurance company might be willing to take on a certain amount of tornado risk in Oklahoma state. That company might price that risk based on 100 years of past data studying the number, severity, duration, locus, clustering (of tornadoes) and collateral damage. But will the insurer write policies with such large nominal amounts so as to bankrupt the company if any or all of these parameters were exceeded (i.e. on the worse side)? That would be a case of ignoring uncertainty – i.e. the future may not look like the past. Another example from further west of Oklahoma: from the perspective of the individual gambler, betting on activities like roulette or blackjack involve finite probabilities and therefore one can say that playing in Vegas is risky. From the perspective of the house though, while there may be data dating right from the ’30s, they always operate under uncertainty. What if someone comes along and breaks the house? Which is why The Strip strips away a slice of chance from their games (the ‘house advantage’) and keeps itself in the game. Now leaving the events of the Sin City in the Sin City, let me turn my thoughts to how retail rats view investing in equities. There is a whole lot of historical data, no doubt but can exact probabilities be assigned to future stock prices? Subjective assessments are done via various models. Investing is about uncertainty, not risk. Gambling is about risk, not uncertainty. Do you gamble or do you invest? 😉

How Many Eggs In Your Basket?

“Don’t put all your eggs in one basket”. That’s what Cervantes made the  rotund Sancho Panza say in his book Don Quixote. The view expressed across the Atlantic, however, was quite different. Mark Twain told us to put all eggs in one basket and to watch that basket very carefully. Wise wits and financial advisors take Cervantes’ cue and tell us to scatter our assets and attention. The saying undoubtedly originated from the simple observation that if you put all your eggs in one basket and if you were to drop that basket, then you’d lose all your precious eggs. If I were a CFA or a wealth advisor I’d have egg on my face if I said that I believed that Mark Twain was right, but since I am not, I am going to exactly do that in this post! It’s important to understand the context in which it’s good to diversify and where it is not. This is the context I am referring to: make a pie chart of your wealth and ensure that you always have 3 – 4 wel diversified slices in it. Within the particular slice of the pie that indicates your equity exposure, you shouldn’t have too many further sub divisions. Many people interpret the eggs in one basket to mean that they need to own multiple stocks and multiple mutual funds!

According to me, it’s obviously important to have a little diversification and redundancy but generally small investors take this to the extreme. They play with woefully small stakes. So even if they bag multi-baggers it hardly grows their personal wealth. Even if you get a 3x return what’s the point if all that you have running on it is a measly 10,000/-? If I have to talk co-variances and correlations, the multi-basket approach only works if the baskets are independent. Which means that it is obviously a great idea to spread your wealth across (mostly non-correlated) asset classes like gold (not too much please!), real estate (uncorrelated really?), stocks, equity mutual funds, fixed income (PPF, bonds, debt MFs) etc. Fixed income may be interesting over a 2 – 3 year horizon if the local interest rates move down. If you noticed, I did not mention insurance since I do not consider that asset class as an investment, sorry.

But it’s a horrible idea to spread your investments across > 15 stocks (just to pick a number, my Kelly Formula post notwithstanding). Why? Because its impossible for a small investor with a daily job to digest all those bits and bytes of information that get generated in the financial marketplace everyday. You can’t monitor multiple baskets beyond a point. By spreading your capital across multiple stocks you are certainly setting yourself up for cleaning the mess that’s soon to appear on your floor. Be careful with those egg shells when you walk, you may bleed (in more ways than one).

If I have lost you or you remain skeptical, then let me try some other way. Let’s try to visualise as to why you may want to keep all your eggs in one basket:

  • You have only one egg [well. you shouldnt be in the markets. Line up to buy Super Lotto.]
  • You have only one arm [I do. I am not ambidextrous – juggling work and finances and home and hobbies is challenging on me. Quality suffers. So I have only one arm to give for monitoring my trades]
  • You need all your eggs [which means dropping one basket with all eggs will cause you similar grief as dropping some baskets]
  • It’s a trash basket [all your eggs are already broken or rotten – i.e. hopeless loss making holdings. I’d strongly urge you sell off all your shares (if they are really broken or rotten) and A) start fresh and B) start reading this post from the top!]
  • You eggactly know what you have [i.e. you’ve focused on a few ideas but really thought very deeply & are honest to admit to yourself what you don’t know]
  • Last time you spread your eggs across baskets you dropped a few of them [This is true in my case and the following paragraph talks about that]

A past colleague and good friend drilled this message into me. Since then (this was nearly 3 years ago) I have consciously tried to reduce the number of positions I have at any given point in time in a bid to improve my performance. I have been resonably able to limit my holdings to a few, and I can now stand up in front of the mirror and talk about the basis for each of my speculation – when bought, how many shares bought, why bought, when will I fold, maximum loss threshold etc. It was impossible to do this when I had > 15 stocks in my portfolio.

The challenge here? As your portfolio size increases having just 5 – 6 stock positions at any given point in time means your stakes go really high. If you cannot make the mental shift to think in % terms and remain rooted to absolute rupee amounts, then this focus will be impossible to achieve. You will either end up being under-invested in equity (since it’s too much work) or have loads of positions to monitor.

Finally, inspired as I am by Mark Twain, let me invent a quote: “Never own more stocks than there are colours in a rainbow!” Am I an egghead or what? 🙂

Rising Prices and Risk

If you agree to the idea shown in the below graphic, would you not agree that as Gold rises and rises, it is getting to be more risky?

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