Tuesday, May 6, 2008

The Nature of Risk

Quotes of the week:
"The first of April is the day we remember what we are the other 364 days of the year." - Mark Twain.

In Honour of April and the financial crisis. (I wouldn't take the quote personally. After all, Mark Twain was an American).

Commentary for the Week:
The Nature of Risk:

Risk is one of those phenomena that leap into any and all discussions on finance even before logic can intrude. When we ask of someone what the Risks vs. Rewards of certain actions are going to be, we are frequently clear on what we mean by rewards but are usually not so clear about what we mean by risk. We frequently confuse risk with uncertainty, volatility and general gut-feeling. These are all important factors on their own, but surely Risk means a bit more. It is not enough to say that things will go up and down, or that one kind of action is 'secure' whereas another is 'risky'. The Truth (and you know that your humble correspondent is all about the Truth) is that there is always risk. Risk is even more pervasive than body odour at my gym, or smelly socks at Juma (no thanks to me I might add - I do my bit for the environment).
Two weeks ago, I recommended to you all a simple (but hopefully not simplistic) model for judging investments. But how does one go about categorizing and defining the risk factor within that model? Usually, there is reference made to words and phrases such as 'secure', 'guaranteed', 'not likely', 'not guaranteed', 'past performance is no guarantee', 'phenomenal', 'spectacular' and my all-time favourite - 'risk-neutral'. But what does all this mean and how can we as investors make some sense out of this? After all, people are paid millions to manage risk at Insurance companies, Trust Companies, Investment Banks and even at our favourite Actual Banks (I know - InshAllah). What makes me think we can second-guess them when they say 'secure' or worse - when they say nothing at all?
Well, it's simple really, the money around which they manage all this Risk is ours, and although one would like to think that they know what they are doing better than us, that is not exactly 'guaranteed', so to speak. So how do we manage Risk for our own money, ourselves - even before we seek help from 'professionals'?

5 Simple questions come to mind:
1. Do I understand the investment, how it works, how my money is supposed to grow, what makes it grow? etc.
a. Failing at this question is called the Risk of Ignorance. It is usually very expensive. If not in this world, then definitely in the next. To guard against it, we must understand fully how something grows in value. If the investment is Real Estate, why that particular location will increase in value more than one 17 blocks away for example. If it is a stock, why that company as opposed to its competition. If it is a mutual fund, why that particular fund manager or strategy as opposed to the other 4000. If it is a portfolio, why each component fits with the others.

2. How many ways are there in which what is being said to me can turn out to be false, or if not false then at least not Totally True?
a. Failing at this question means you are at Risk for False Expectations. For those of us who are married, we are very familiar with this risk. In financial matters, however, this risk is frequently overlooked when discussions about Rewards begin (again, just like marriage). My advice would be to rewind a bit and go over whether you understand how many ways the rewards can be undermined by fairly common situations. Think of it as buying a cow - if it doesn't pass on into Bovine heaven immediately (which would be a catastrophe such as the one we discussed last week), it will still produce milk. But if someone is feeding the cow pop-corn instead of hay, it will not perform by producing Grade 'A' milk but by producing manure. Definitely not the reward we were hoping for.

3. How likely is it that any of these 'Reward-reducing' situations will arise?
a. This question begins to quantify the Risk of Loss and its probability. The loss can be of faith, of returns, of principal or of face - the key is to figure out the probability for each situation that can reduce rewards. Using our beloved cow once again, what is the probability that someone will sneak into the barn and substitute hay with pop-corn? On the other hand, what is the probability that the hay is genetically-modified and may induce madness? Once you have these probabilities figured out, you can determine what the most likely scenario for the cow really is - whether it is reasonable to expect that the cow will actually produce the Grade 'A' milk you desperately want.

4. How severe will the loss be if it is 'Reward-reducing'?
a. This question leads us to determining whether we are at Risk for Catastrophic Loss - which is perhaps the most important determination of all. This is when amounts at risk or issues at risk are of the kind that induce butterflies in our tummies even when we are already full of Biryani. Usually, these involve some form of leverage / loans / margin. They can also involve life-savings. For those who are some way along life like my balding, grey-haired self, this becomes more and more of an issue. Personally, I try and stay away from anything that exposes me to catastrophe, particularly cows. One must try and spread one's nest-egg into a few baskets that one understands fully. Personally, I do not always succeed, but at least I know that the responsibility, decisions and blame are mine alone.

5. What is my alternative?
a. Failing at this question puts us at Risk of Opportunity Loss. If we dither, over-analyze and over-complexify, we will lose the opportunity to act in a timely manner. Ideally we want to buy the cow when it is reaching milk-producing age, not when it is entering its pop-corn driven Madness. Similarly, if we are in the path of an oncoming train, whether we jump to the right or the left, or whether it is expected to reach the next station on time is quite besides the point.

Armed with this knowledge and framework, I am sure you will make if not Trillions, then at least better decisions. You can even take the last two questions and make a nifty 2x2 Risk-Matrix. Please don't get excited about Cows as the investment vehicle of choice - send me neither Milk, nor the other By-product, I am partial to Soya Milk myself.

Finance News:

1. Have no fear, new regulations are here. Too bad more power is being given to the people who got us into this mess in the first place ... Even though we protest to the contrary at every opportunity, I guess at heart, we really believe that the politicians know what they are doing ... Just like marriage, a triumph of 'Hope over Experience' ... read more here

2. Blanket immunity is about to be granted for the Canadian version of the Sub-Prime mess ... read more here

3. Lehmann Brothers, the investment bank that is just larger than Bear Stearns was, raises over $3B (I think it took Bear Stearns something like 80 years to become worth $3B) ... read more here

4. Useful advice to guard against identity theft ... a growing problem in North America ... read more here

Economic News:

1. Some evidence that food prices have been bid-up by small scale investors. An interesting but ultimately unsatisfying explanation ... read more here

2. An excellent article on how Alberta's Oil Sands are using up both Natural Gas and the Province's fresh water. Did you know that the largest dammed (as in water-dam) pool in the world right now is not the Three Gorges in China but rather Syncrude's pool of contaminated water? ... Shocking ... read more here

3. Are Student Loans going to be the new sub-prime? ... (hat-tip to Suhail Ahmad) ... read more here

4. Story about some homes in the US that are worth less than their copper pipes ... read more here

Islamic & Middle East Finance:

1. An insight into Saudi Arabia's economic debates ... the burning issue of the day is not the almost suicidal peg to the US$ but whether women should be allowed to drive ... come on people ... read more here

2. UAE Takaful Company IPO oversubscribed 43X ... irrational exuberance anyone? ... read more here


1. How to start up your own country ... (recommended only for reading purposes, not for hatching actual plans) ... read more here

2. The best advice that the CEO of PIMCO - William Thompson ever received ... (this is particularly good for young readers starting out in life) ... read more here

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