Risk vs Consequences
I’ve recently been reading a book called ‘Alone on the Wall’, the story of rock climber Alex Honnold.
I’m not climber by any stretch, but I’ve been interested in his story ever since I heard he’d become the first person to ‘free solo’ El Capitan in Yosemite.
What this means is, that he’d climbed it without any ropes or safety gear.
If you’ve been to Yosemite and looked up the face of El Capitan you’ll have a sense of how amazing this feat is. El Cap is a sheer granite rock face that rises 1,097 vertigo inducing metres from the valley floor of Yosemite.
When you see the pictures of Alex climbing from a distance he looks like a speck on the wall. You can see he’s a long way up, but it is only when you see a picture looking down on him with the valley in the distant background that you can truly appreciate his achievement.
Frankly, I get queasy just looking at the images and the footage of it. I hadn’t looked at it until I started writing this article, but even now, 30 minutes after viewing it I’m still feeling somewhat ill.
Part of my interest in reading the book was in understanding the psychology of someone who would take on these challenges. Was Alex just a mindless risk taker, always pushing the boundaries in the search for a bigger rush? Did he have an appetite for self destruction? What was driving him?
Turns out that Alex is quite self-aware and has given considerable thought to these issues.
He also has an exceptionally strong mind.
He focuses on the distinction between Risk and Consequences.
As he explains it, the risk in climbing comes down to the difficulty of the climb itself, his climbing ability and his ability to execute his skills, and the conditions he is climbing in.
Of these, he can control the first and last, simply by choosing what to climb and when to do so.
He has honed his skills to an amazingly high level.
But it is his ability to put his skills into effect that is his key attribute. He is able to control his mind to such a high degree that he is not overcome by the fear of the consequences of failure.
He rationalises that the degree of risk is unchanged by how far off the ground he is. So, if he faces a difficult section 2 metres up the wall his approach should be no different to when he is 500 metres up. It is just that the consequences of a fall from 2 metres will merely hurt whereas a fall from 500 metres will kill him.
Alex’s distinction has strong parallels to the world of business and finance.
Unlike Alex though the attitude most of us have towards risk changes with size of the potential consequences – that is our altitude.
When we begin (whether it’s our career, a business or a personal financial journey) we don’t have anything much to lose and so are generally willing to try anything.
For instance, we might be willing to invest our time and all of our (small) savings into establishing a business when we are young because if it does fail we might only lose a relatively small amount of money and the time we invest into it – whereas the payback if we make a success of it could set us on the path for a strong financial future.
We might also be willing to ‘bet’ and put all of our savings into a speculative share because the upside would make a significant difference to us whereas the downside if we lost the lot might only take a month or two to build up again.
Plus, our naiveté more than likely means we don’t truly appreciate the risks (or the likelihood of things going wrong)
As we get older though, we often have other people to worry about and more to lose. We build a life over time and it becomes harder to put that at risk – and especially hard to put that at risk for our dependents. So the risks we take on become more calculated, we have backup plans and strategies to safeguard our position, and the amount of money we are willing to risk on a single position (as a percentage of our overall wealth) becomes smaller.
That limits the speed of our progress but we are generally willing to accept this as a trade off because we don’t want to risk falling off the cliff and crashing back to earth.
In finance terms, one of my favourite stories that illustrates this involves the late Kerry Packer.
Not known for being shy and retiring, Kerry was at a casino gambling when another patron tried to join his table and was rebuffed. The Texan didn’t take too kindly to this and objected loudly, proclaiming that his importance and wealth of $100 Million should entitle him to play. KP reportedly looked at him squarely and in one of the best put downs ever uttered suggested that if he really wanted to gamble he could flip a coin for $100 Million.
Unsurprisingly, the man beat a hasty retreat.
While this is an extreme example, the sentiment is supported by the findings of Behavioural Economics. Put simply, most of us fear potential losses to a far greater degree than we do the equivalent gains.
It’s not rational, but few of us are truly able to separate the consequences from the level of risk involved in a decision.
Most climbers are not like Alex Honnold. They don’t bet it all on one toe hold or hand hold. They use ropes and harnesses and clip onto safety points attached to the wall they are climbing. If they slip and fall the rope will catch them and save their life (although it could still be a painful event). The more you limit your potential fall, the slower your progress.
Investors do the same thing. They try to control (or limit) the amount their investment portfolio can drop by diversifying their investments. The greater the focus on downside protection, the more you limit the upside potential – but this is an acceptable trade-off which allows you to sleep more comfortably at night.
The biggest problem facing investors at present is in truly quantifying the risks they face.
Rock climbers have a scale that measures the difficulty of any climb. It is universally accepted, and a useful tool in assessing whether a climb is within your capabilities – or whether the risks are too great.
It is constant and unchanging.
Investors have long used interest rates paid on long term government bond (the so called Risk Free Rate) as a yardstick to benchmark other investment opportunities against. The assumption is that (solid) governments will always repay their debts, while every other investment has a degree of risk that this will not be the case – so they should pay investors a greater return to incentivise them to take on this additional risk.
The risk free rate of return is used to calculate the level of return that is acceptable given the level of risk being taken – but the relationship is not a linear one. With every decline in the level of interest rates there is a multiplier effect on the price of other assets, and this has driven the growth in the prices of shares and property over the past 20+ years.
With interest rates around the world at historic lows, the risk to investors is that this trend will reverse at some point and interest rates will eventually rise – and the positive impact on asset prices will likely be reversed.
What we don’t know is when this will occur, or what the pace of rate increases will be.
We do know however that this will change the valuations placed on other assets, and could result in dramatic price movements.
The decision for you as an investor to make now is: where do your concerns lie? Are you most concerned with the speed of your progress, and are you prepared to accept a painful drop if things go wrong as the trade-off for targeting a faster ascent? Or are you more fearful of the potential falls, and as a result you are willing to sacrifice your progress to limit those falls?
What is acceptable risk to you is probably a world away from Alex Honnold’s attitude – and pontentially quite different to mine.
What is important for you though is that you make an informed decision that you are comfortable with now, but that you can also live with if the market turns.
