Thinking About Risk: The Mind Your Portfolio Principle

“To take control of one’s own life or financial affairs may seem to create uncertainty, but taking control is a prerequisite of security in a world that is inescapably uncertain.” — The Long and The Short of it, John Kay

So much of our choices are determined by our attitudes to risk, yet we don't often discuss what that actually means. Everyone agrees that how you feel about risk has a big impact on how you manage your money, whether you should switch jobs or even whether to get married.

For those who wish to avoid risk as much as possible (or who seek security), it's easy to fall into a trap that leads to making worse decisions and more risk. Here's how it works.

Don't confuse risk with uncertainty

A very common, and understandable, mistake is to confuse risk with uncertainty (or, on the flip side, security with certainty). It is human nature to seek security in the people, places and routines that we know, and to view new things and uncertainty with a healthy scoop of scepticism. However, certainty is knowing what is going to happen in the future, and it is quite possible to know what is going to happen without feeling very secure. Consider for instance the prisoner on death row who knows he will be put to death tomorrow. He is certain, but probably doesn't feel very safe. It is true that most of the time certainty makes us feel secure, but that is precisely why the fact that they are used so interchangeably can be dangerous.

The truth is that the world is, as John Kay points out in the quote above, 'inescapably uncertain'. Even if you are able to avoid the dangers that you know about, there is nothing you can do about the 'unknown unknowns'. These are the events that you can't possibly take action to avoid because you didn't know that there was something you didn't know. The terrorist attacks on 9/11 were an unknown unknown, for example.

Making decisions in life based on avoiding as much uncertainty as you can means that:
a) You will still get your ass kicked by the 'unknown unknowns' - the things you didn't know you should be looking out for. And,
b) You'll fail to capture any of the upside that can come with taking some risks.

To demonstrate this, take the example of investing money. Which is more risky: investing £1000 by buying shares in Apple, or investing £500 in a mining company in Mongolia? Individually, Apple is clearly the safer investment. The chances that Apple goes bankrupt are astonishingly small, and you don't know anything about Mongolia or mining companies.

However, you can't assess the riskiness of an investment individually, but must assess how it compares to the rest of your portfolio of investments. If all of your money is in big corporations in Western Europe and North America then each individual investment may be quite a safe bet (big companies in the West generally tend to grow in value rather than go out of business), but overall you've taken some big risks.

What happens if there is another financial crash tomorrow? What if Trump declares war on Canada in 2 months time and the US Stock Market takes a nose dive? These are the pesky unknown unknowns mentioned above. It doesn't matter how safe each company is individually, if all of your money is invested in the same type of companies in the same part of the world then you've opened yourself up to the chance that something affects all of them at the same time.

By contrast, the financial success of the mining company in Mongolia is almost entirely independent of the success of Apple and the big Western Corporations that you're already invested in. Sure, there's a bigger chance that you might lose your money, but if an unknown unknown strikes then your diversification will pay off because it won't be your whole portfolio that's down the toilet. What looks like a much more risky investment taken by itself could turn out to be the safer choice! (N.B. This is assuming that you have good reasons for thinking that the Mongolian company is fundamentally valuable - no one is saying that you should actively seek out bad investments. Only that your investments should be diverse in nature.)

As John Kay summarised it:

“A portfolio that consists of a collection of idiosyncratic but individually risky investments . . . can be a low-risk portfolio. Such a portfolio may carry a lower risk, in fact, than a collection of blue chips – stocks that are individually safe, but whose returns are likely to be strongly correlated with each other.”

— John Kay, The Long and The Short of it

This is called the Mind Your Portfolio Principle: Always look at risk in the context of your portfolio as a whole, rather than its individual elements. Sometimes the safest thing to do is make an investment that is individually high risk, but complements your portfolio as a whole.

What this means outside of investing your money

The overall lesson is this: don't avoid risks because you like the feeling of security that you get from being certain. It is a far worse mistake to put all of your eggs in one basket because that's what you know, only to find that the world is inherently uncertain. It is possible to take individually risky actions that have the potential to bring the larger rewards risks bring, without compromising your need for security. In fact, taking some risks might be the safest thing you could do.

Here's John Kay's advice once more:

“Instead of devoting time to speculation about what the future holds, recognise that the future is inescapably uncertain. Equip yourself with what will be a portfolio that will be robust to many different contingencies. Such diversification is the most effective means of coping with a complex world. ”

— John Kay, The Long and The Short of it

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