My brain is flawed. It is a flawed lens through which I see reality. This is true of both mouse brains and human brains. But a human brain is a flawed lens that can understand its own flaws—its systematic errors, its biases—and apply second-order corrections to them. This, in practice, makes the lens far more powerful. Not perfect, but far more powerful.
Take our zero-risk bias for example. This is our preference for reducing a small risk to zero over a greater reduction in a larger risk.
It plays to our desire to have complete control over a single, more minor outcome, compared to the desire for more — but not complete — control over a greater, more unpredictable outcome.
We are strange and imperfect organisms as we seem to prefer large decreases in small risks to small decreases in large ones, even when the overall benefit of the latter is vastly superior to the former.
Zero-risk bias is an extreme form of this behavior, often triggered under conditions of uncertainty.
In fact there are circumstances where zero risk is worth paying for – if you’re a home owner the elimination of any possibility you might lose your home has a very high value compared to nearly eliminating the risk.
But generally, in investment, zero risk equates to very low returns.
Risk: Severity and Duration
Let’s take a look at the two parts of risk: How severe it is, and how long it lasts.
In investing, there’s too much emphasis on the former and not enough on the latter. A 20% crash that rebounds in a few months or a year probably isn’t a big deal. But above-average fees paid on your unit trust and left unchecked for decades can be devastating.
Mitigation: The zero-risk bias can be reduced by re-framing the problem, which suggests that it’s not unchangeable but is a consequence of the way we think about situations. Focusing on the other side of the equation can help: investing in US Treasury bills back in 2008 would have reduced your chances of losing any money to zero but would also have decreased your chances of making any to about the same amount.
By and large it’s best to re-frame in terms of absolute quantities rather than relative proportions if possible.
So, when you put on a stock trade have you planned to lose and how much? If not, losses will come as a shock and may destabilize you, in which case you risk making decisions in a compromised state of mind.
Keep in mind that failure is a natural part of any learning process. If you aren’t failing sometimes, then you probably aren’t taking enough risks.
Risk: Quantifiable or Messy?
Let’s look at two other parts of risk: Is it quantifiable or just outright messy?
A parable might be opportune here: A group of hikers in the wilderness came upon a bridge that would greatly shorten their return to their home base. Noting that the bridge was high, narrow, and rickety, they fitted themselves out with ropes, harnesses, and other safeguards before starting across. When they reached the other side, they found a hungry mountain lion patiently awaiting their arrival.
So, it is kind of good to understand the difference between the quantifiable and the messy risks.
And then live with the understanding that no risk can be reduced to zero and that you can create risk by trying too hard to eliminate it.
Risk is the seed of opportunity, and necessary to get ahead in almost every field.
So, being fully aware of the risks, taking responsibility, living with uncertainty and rewards should follow …
As long as we risk less than our potential reward. Always!
“In real estate, the key is location, location, location. With money management, the key is risk control, risk control, risk control.” – Bruce Kovner, Trader
“Diversification reduces risk, increases predictability, and boosts returns.” – Robert Brokamp
“The funniest thing about markets is that all past crashes are viewed as an opportunity, but all current and future crashes are viewed as a risk.” – Morgan Housel
“On a long enough timeline, the survival rate for everyone drops to zero.” – Chuck Palahniuk, writer Fight Club Movie