Deluge-Ons And Disaster: Taking An Honest Look At The Risk Of Extreme Events

by: Arete Asset Management

Summary

The effects of disasters are often worse than need be due to our tendencies to be less-than-completely honest in assessing them.

This behavioral quirk is relevant to investors because it also applies to financial disasters.

The overarching goal for most investors is to "match the lifespan of your assets with the lifespan of your liabilities"

One of the greatest threats to attaining that goal is to suffer infrequent, but disastrous losses.

As a result, most investors should seriously consider an absolute return approach to investing which explicitly calibrates exposure to risk assets based on risk and opportunity.

In light of the recent flooding in Houston, it should be fresh in everyone's mind that disasters have the capacity to fundamentally reshape peoples' lives. As truly unfortunate as this is, there are lessons that can be learned. First and foremost, when there is significant risk of severe harm, it normally makes sense to get out of the way. Many don't.

This just goes to show that we often compound the harm of disasters by making bad decisions when confronted with such possibilities. We regularly underestimate the probability of trouble striking and we often fail to fully account for the magnitude of harm. While these behavioral quirks can cause undue suffering in the wake of natural disasters, they can cause just as much pain in the event of man-made financial disasters.

Tim Harford recently revealed some interesting research on the subject in the Financial Times [here]: He noted, "Robert Meyer and Howard Kunreuther in The Ostrich Paradox argue that it is common for institutions and ordinary citizens to make poor decisions in the face of foreseeable natural disasters with tragic results." Although there can be many reasons for this, "The authors focus on psychological explanations. They identify cognitive rules of thumb that normally work well but serve us poorly in preparing for extreme events."

One of these "mental shortcuts" is described as "a tendency to focus on recent experience." The authors call this amnesia bias but it is also known as recency bias in the field of behavioral economics. This bias occurs because recent events are recalled more easily than older ones. As a result, recent events often play a disproportionately large role in establishing a baseline for what is considered normal.

Since extreme events such as hurricanes are relatively infrequent, recency bias causes people to underestimate even those infrequent occurrences. Immediately prior to Hurricane Sandy, for example, "few people had plans to evacuate". More recently, immediately prior to Hurricane Harvey, CNN reported [here], "About 50 to 60% of residents decided to stay in the city [Rockport, TX] through the storm." Part of this was because even the mayor of Houston did not encourage residents to evacuate voluntarily. As the Economist reported [here], "For most of the cities in the path of the storm, including Houston, a sedentary stoicism seemed the most reasonable response." In each case, the absence of recent hurricanes appears to have lessened the perceived threat of imminent ones.

Another cognitive bias that Meyer and Kunreuther highlight is what they call "single action bias". As they describe, "taking one or two positive steps often feels enough" in instances of being "confronted with a worrying situation". When Hurricane Sandy approached, it was odd that, "even those who had storm shutters often had no intention of installing them." Apparently, installing the shutters seemed to be a step too far.

These mental shortcuts also apply just as well to man-made disasters, a reality with some poignance since it has been ten years since the financial crisis really started wreaking havoc. Prior to that event, many homeowners and investors had experienced unusually large increases in home prices. Rather than viewing such increases as anomalous and unsustainable, many extrapolated such gains far into the future in a clear display of amnesia bias.

The financial crisis was different in one key respect, however, and one that is especially relevant to investors. In the run-up to the crisis, as the "storm" was approaching, there was no widely recognized authority such as the National Weather Service to identify the storm and to sound a warning. The Federal Reserve was arguably the closest to being such an authority, but its governors repeatedly de-emphasized any potential problems with home prices. Worse, they seemed to be afflicted by recency bias themselves. When questioned in 2005 about the possibility of a decline in house prices [here], Fed Chairman, Ben Bernanke, responded, "We've never had a decline in house prices on a nationwide basis."

The absence of reliable official storm warnings in the realm of investments places even greater importance on explicitly incorporating risk management into one's approach. In this regard, Ben Hunt points investors in the right direction [here] by suggesting, "It’s more important to see the forest than to see the trees."

More specifically, Hunt describes one of the most important qualities of successful investing as "matching the lifespan of your assets with the lifespan of your liabilities" and calls the endeavor to do so "part of the investment meta-game". He distinguishes the meta-game from "the immediate game — picking this stock or picking that stock" and describes it as "the game behind the game". The absolutely critical lesson is this: "It’s more important to play the meta-game well than to play the immediate game well."

An important practical aspect of playing the meta-game well is managing around the really big risks by deciding when, and when not to, engage in the immediate game. In other words, it is critical to determine when the weather for investing is fair and when it is potentially devastating.

Seth Klarman highlighted exactly this point in his salutary work, Margin of Safety [here]. According to Klarman, "Absolute-performance-oriented investors ... will buy only when investments meet absolute standards of value. They will choose to be fully invested only when available opportunities are both sufficient in number and compelling in attractiveness, preferring to remain less than fully invested when both conditions are not met. In investing, there are times when the best thing to do is nothing at all."

Perversely, doing nothing at all is almost impossible for most financial professionals. As Klarman describes, "Most institutional investors measure their success or failure in terms of relative performance. Money managers motivated to outperform an index or a peer group of managers may lose sight of whether their investments are attractive or even sensible in an absolute sense. Instead of basing investment decisions on independent and objective analysis, relative performance-oriented investors really act as speculators." As a result, "The great majority of institutional investors are plagued with a short-term, relative-performance orientation and lack the long-term perspective that retirement and endowment funds deserve."

Klarman goes on to describe why this happens: "The pressure to retain clients exerts a stifling influence on institutional investors. Since clients frequently replace the worst-performing managers (and since money managers live in fear of this), most managers try to avoid standing apart from the crowd. Those with only average results are considerably less likely to lose accounts than are the worst performers." He concludes with one of the dirty little secrets of the investment business: "The result is that most money managers consider mediocre performance acceptable."

The practice of relative return investing is even more pernicious than that, however. Klarman explains, "Unfortunately the important criterion of investment merit is obscured or lost when substandard investments are acquired solely to remain fully invested. Such investments will at best generate mediocre returns; at worst they entail both a high opportunity cost—foregoing the next good opportunity to invest—and the risk of appreciable loss." Relative return investing is like having a hurricane approach and not taking any precautionary measures. It's worse, though, because many investors are not even aware that they are being exposed to appreciable loss.

Klarman's exposition highlights the merits of absolute return investing in regards to playing the meta-game well. Although absolute return investing is often considered to be a somewhat esoteric approach more befitting expensive hedge funds, large endowments, and exclusive family offices than individual investors, the nature of the practice is much more prosaic. It really just involves analyzing situations, valuing securities and investing only to the degree that opportunity warrants. It is based on the experience that sometimes markets provide terrific opportunities for future returns and sometimes they provide terrible opportunities for future returns. Exposure should be determined accordingly.

As common-sensical as this approach seems, it is almost diametrically opposed to the "short-term, relative-performance orientation" that plagues "the great majority of institutional investors". This is not to say that most money managers and advisers are bad people - that's not true. What it does indicate is that most money managers and advisers must operate within a business context that makes it extremely difficult to express the type of "long-term perspective that retirement and endowment funds deserve."

All of this creates a bit of an interesting paradox for individual investors. On one hand, the task of investing has become more challenging at the same time that it has become even more important. High valuations make future returns extremely unattractive and high levels of debt and inter-connectedness make the financial system more vulnerable to disaster. At the same time, investors increasingly must tackle investment issues themselves despite having other priorities and limited resources. This isn't anybody's fault, but it is a reality to confront. Uniquely, the absolute return approach not only simplifies the investment task by reducing day-to-day noise, but it also affords the structural advantage over most institutions of a long-term perspective.

One way to think of absolute return investing is simply as an exercise in honestly assessing investment opportunities and then acting accordingly on those insights. As Martin Sandbu describes [here], the big lie of capitalism is "that the market values of financial and other assets accurately reflect the economic value they represent." Given the tendencies of amnesia bias and other psychological shortcuts, it is easy to establish narratives that justify current prices. That doesn't make them right. The best way to avoid appreciable losses in securities is to analyze the value of the economic value of claims they represent and to resist overpaying for them. Otherwise, the eventual result is "the horrifying realisation that financial claims accumulated over the previous boom years did not add up ... In brief, the wealth that people thought they possessed did not in fact exist."

This brings up another important point. The psychological shortcuts and tendencies and lies that we occasionally engage in are not exclusively the purview of individual actors; they can be assumed by society as a whole as well. And, as Sandbu describes, "The most resilient societies are those that know the truth about themselves. Deceit makes for brittleness."

This insight is reflected in the warning systems for various types of disasters. An often unheralded development is that early warning systems have vastly improved across many domains. Weather forecasting systems now detect developing hurricanes several days before they strike land and determine various possibilities for the storm's path. This incredibly valuable information gives potentially affected communities the opportunity to mitigate damage by preparing accordingly.

In a story that hasn't made big headlines in the US, India and Bangladesh have also been enduring significant flooding during their monsoon season. Although damage has been extensive and up to 1,000 Indians have been killed in floods this year, the Economist notes a silver lining [here] "Forecasting has improved. Text messages are now used to warn of disasters. The days when cyclones would leave hundreds of thousands dead seem now to be in the past." The vastly smaller scale of deaths is attributed to "investments in risk management". In other words, this is a case in which the honest assessment of risk has increased the resilience of communities.

Interestingly, and conversely, far less effort has been exerted in honestly assessing the risk of financial disaster. Well-honed tools for valuing markets exist and yet are often derided. Terrific studies of financial history exist and are often ignored. Nobody criticizes the weather service for forecasting a hurricane and yet choice epithets are often hurled at those who warn of investment risks. This state of affairs begs the question as to why, when it comes to financial assets, there aren't more "investments in risk management" and is also suggestive that the dearth of more honest inquiry "makes for brittleness".

All of these lessons essentially boil down to the same thing: The best way to manage risk is to be completely honest about it. As the entrepreneur and hedge fund manager, James Altucher put it, "Honesty is the fastest way to prevent a mistake from turning into a failure." Extreme events tend to test our ability to be completely honest about the probability and magnitude of harm, but that's also what makes them so instructive. The bottom line is to focus on the things that matter most. For investors the key goal is to play the meta-game well by "matching the lifespan of your assets with the lifespan of your liabilities". And the best way to do that is to actively manage against the risk of disaster by rejecting relative return investing in favor of the absolute return approach.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.