Thursday, November 03, 2005

Understanding Risk & Fear of Consequence

As human we are programmed to tackle physical risk instinctively but as an investor we have to learn to manage risk in every investment decisioin we take.

Understanding Risk:
"Price & probability are not enough in determining what something is worth. Although the facts are same for everyone, the utility is dependent on the particular circumstances of the person making the estimate. There is no reaon to assume that the risk anticipated by each individual must be deemed equal in value"--Daniel Bernouli in Peter Bernstein's "Against The Gods: The remarkable story of Risk"

Reflecting upon the above paragraph I found a relationship between understanding risk and portfolio management. I would serve the learnings in the form of a game to make it more reader friendly & easy to understand. (I myself learnt the lesson by putting myself in the scenario that follow)

Game:
Simple game of Coin toss. You have to bet on either head or tail. You win if you are right.

Scenario 1:
You bet Rs. 10 & if you win you will get Rs. 100. Will you play? Mathematically the expected value is Rs. 50, so one can easily conclude that you should play. I will.

Scenario 2:
The rules remain the same, only change that comes about is all you have is Rs. 10. If you win you become 10 times as much richer as you are now, on the other hand if you lose you go broke. Will You play? I won't.

Anomaly:
Scenario 1 looks like a very favorable bet but scenario 2 looks like a very risky proposition. Mathemetically nothing has changed to make scenario 2 more risky than scenario 1. What is that has made Scenario 2 more risky (or atleast make it look more risky)? The answer is fear of consequence. Hence we can conclude that, risk is sum of probability of an event happening & price you pay for it & fear of consequence.

Risk = Probability of the Event & Price paid & Fear of consequence

What makes this so important is that the facts are same for everybody it is the fear of consequence that differs for everybody & that in effect changes risk factor from person to person. (Think of a person who has Rs. 1,000 and what do you think he will do in scenario 2)

Scenario 3:
In the same game, you can bet Rs.1 from your total of Rs. 10. If you win you get Rs. 10 for your Rs. 1. That is you can play the game 10 times with the money you have. Will you play? I will.

Reflecting on Scenario 3 & relating it to Investing:
Mathematically speaking, the expected value is same for Scenario 1, 2 & 3, Rs. 50. But I think we will be attracted towards scenario 3. Why & what does that mean?

Diversification:
The reason is bounded rationality. We have no expertise as to predict the outcome. All we know is that probability is 50% and the more times we play the game the more the chances that the result will be near the mean(regression to mean). But still we can go broke, 10 tails or 10 heads in a row is not an improbability, just that it is highly improbable. (I remember reading somewhere that the probability of that is around 0.1%). It reminds me of beautiful quote by Ben Franklin,

"In this world nothing is certain but death & taxes"

Satisficing:
In scenario 1 & 2, if you win you make 900% return on your portfolio(from Rs. 10 to Rs. 100) & negative 100% if you lose. And the probability of that happening is good 50% on either side. But in the scenario 3 you cannot think of making 900% return, but you will hopefuly come out a winner, because you need to win once from the ten chances to take your principle back. But the probability of winning 10 times is around 0.1% (getting 10 heads or 10 tails simultaneously). So you have to be a satisficer in giving up some probable extra return for much needed safety.

Conclusion:
All said & done, this quote by Warren Buffett is even more important to understand and could find nothing better (a satisficer, that I am)

"Risk comes from not knowing what you're doing"

2 Comments:

Anonymous Anonymous said...

great post. This post reminds of buffett's comment in his annual reports, where he has told his shareholders that he operates from an exceptional position of financial strenght (in terms of the debt of the company ) for berkshire. He is not comfortable with 99:1 odds as the risk of losing everything (with a 1% probability) is also too high for him

5:27 AM  
Blogger Dipu said...

Isnt this was Money management is all about?

8:22 AM  

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