Which Risk Are You Managing?

The issues of risk and how we talk about "managing" it have caused me a lot of trouble for years. I have never really understood how we can claim to manage risk.

It seems to me that risk, by definition, is very hard to control. In my mind, risk is what you have left over after believing you have thought of everything.

As I have tried to understand the topic more, I have come up with a few examples that might help clarify the issues, or at least start a healthy discussion.

The Risk of the Mountains

I spend a lot of time in the mountains in situations that might be considered risky. I realize my activities involve risk and I do everything I can think of to mitigate the risk of being harmed.

But when I look back at the risk to which I expose myself, I realize that I am lucky to be alive.

But here’s the tricky part: I didn’t know that at the time.

Even though I did everything I could, based on my knowledge and experience, to "manage" risk, the biggest risk of all turned out to be what I didn’t know, events I never imagined. 

Even if you do everything right and follow all the rules designed to keep you safe, what often kills people in the mountains is the stuff they never see coming. 

The Risk of Finance

In 1916, Frank Knight was a doctoral student at Cornell University working on his dissertation that was later published as Risk, Uncertainty and Profit. Knight made the now-famous distinction between risk and uncertainty.

According to Knight, risk is randomness with knowable probabilities. Risk can be measured and presumably managed.

Knight defined uncertainty as randomness with unknowable probabilities. Randomness is all the stuff left over after we think we have thought of everything.

Because these unknowable risks can’t be measured, they certainly can’t be managed. Knight’s work forms the foundation for how we think about risk in our industry.

Managing Risk vs. Uncertainty

Based on Knight’s work, we’re referring to managing randomness with known probabilities when we discuss risk management. In the sterile lab of modern finance, risk equals volatility.

So, we assume the range of outcomes is pretty much fixed within a normal distribution (bell curve). We assume we know, can measure, and therefore, manage risk.

But in the real world, there is also uncertainty.

In fact, the greatest risk to our clients’ portfolios are the things left over after we think we have thought of everything.

It is often said that the last four words of any great investor are "this time it’s different." But do we really believe the limited historical data we have represents a complete set of outcomes? Is there any room for the possibilities of the unknown unknowns?

Clients think risk and uncertainty are the same things.

When we talk about risk management, clients think about risk in general and not as an abstract academic idea. This difference in the way we communicate risk leads them to expect things we simply can’t deliver.

My point is not that we should run to the hills and grow our own vegetables, nor should we ignore the prudent risk-management tools we have used in the past.

But we do need to review the role that uncertainty plays in portfolio management and how we communicate this reality to clients.

Open conversations about the nature of risk and the uncertainty we face when making portfolio decisions can go a long way toward setting realistic expectations and helping clients understand that even after all we can do, the future is still uncertain.

Our job is not to forecast exactly what will happen, but to be there to help them deal with events as they come.

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