What Is Risk?
Read in 5 mins
Over the last 20 years as a participant in the jungle that is the financial markets, the one question I am asked the most is ;
“What is the most important thing I need to master to become a profitable trader/investor?”
The fact is that there are dozens of ‘most important things’ you need to master so it’s the wrong question to be asking. That said, the topic of risk is certainly one of the most important things.
Profitable traders and investors do the following 3 things at a high level as it relates to risk:
Understand what risk is
Recognize different types of risk
Control risk
I have learned a lot from the writings of Howard Marks (Founder of Oaktree Capital) who writes about the topic eloquently and frequently in his yearly investment memos.
Ultimately everyone has a unique and personal relationship with how they view risk, and over the years I have made all the mistakes possible with my own money on the line. That is the best education one can get, although it is slow and expensive!
Today I want to discuss how I think about what risk is, and how I try to understand it.
In the crypto markets, I see the majority of participants, sophisticated or otherwise, greatly underestimate the risk they are taking. The following statements and thousands just like them swamp our Twitter feeds daily.
“Bitcoin can’t go back to $20K” - cryptosuzy143 (March 2022)
“ Terra Labs will never let LUNA go to 0” - lunatic4life89 (every day for 6 months before it went to 0).
The crypto markets this year should have taught everyone a very important lesson about defining risk, understanding it, and then trying to recognize its various forms.
Risk means more things can happen than will happen - Elroy Dimson
This is a thought-provoking statement that strikes at the heart of every discussion about what risk is.
I think about risk as a range of outcomes with varying probabilities. How do we quantify it though?
Volatility is often confused as being risk because volatility is easily quantifiable and measurable. I think of volatility as an indicator of the presence of risk but not as risk itself. It is a symptom of risk.
The point is, that quantifying risk in advance is impossible. We can’t quantify the risk of something happening in the future. We can all have an opinion on what the risk might be, we can try to estimate the probabilities, but we can not quantify it.
Therefore, it is impossible to know how risky or safe a portfolio or an investment is ahead of time. We can try to simulate it using historical data but in my opinion, those numbers are useless in the real world.
It gets worse. We can’t even quantify risk after the fact. How do we know if a profitable trade was risky or not? Did we lose money because we got unlucky? Was it a safe bet that was always going to be profitable?
The outcome of an investment is no indication of how risky or safe it was.
So we can’t quantify risk ahead of time and we can’t quantify it after the fact. So where does that leave us?
Is driving around town a risky activity? How risky? Well, we could look at data relating to deaths caused by car accidents and try to compute how risky we think driving is. Right?
The town of Drachten in Holland removed all traffic controls and lights. You would expect that there would be chaos and carnage as a result. The opposite happened. Traffic flow doubled and fatal accidents fell to zero. Why?
Well think about it, without all those controls, people were forced to be very careful while driving which resulted in way fewer accidents and zero deaths.
Before the subprime crisis in the US, there had never been a nationwide wave of mortgage defaults. Investors were convinced that mortgages were safe. This led to a lowering of credit standards which led to the issuance of mortgages so weak that they almost brought down the entire financial system.
Therefore we can conclude that the risk of an activity often lies not in the activity itself, but in how participants approach it. Trading does not have to be a risky activity. How you trade can be very risky though.
Risk is counter-intuitive.
Now think about the state of the crypto markets in Dec 2021 and try to remember what risk the majority of folks were assigning to the activities they were taking. Why were they behaving that way?
Risk is hidden and deceptive.
Loss is what happens when risk (potential for loss) collides with negative events. The absence of events does not eliminate the risk that exists.
The riskiness of an investment only becomes apparent when the investment is tested.
This is where the majority of the crypto market went wrong this year. The misconception of what risk is, and where to look for it, resulted in the market as a whole believing that their investments were safer than they were.
The point is that risk is uncertain.
A definition of risk that I am comfortable with is ;
Risk is the possibility that from a range of uncertain outcomes, an unfavorable one will occur.
In that context, making investment decisions in crypto becomes an easier proposition.
Stay in motion.
Important Links
 | A guest post by
|
Invaluable. Thank you Nick
Thanks for reading Steve 😃