why do computers never give us a wrong answer ..?
because we talk to them in a language based on logic (aka programming languages); & there is no room for mis-interpretation or confusion ..!
looking differently, a machine or human behavior is based on the language used; so a person’s behavior is based on how vast and subjective / diplomatic language that he uses …
or people behave as per commonly used words and phrases used in a language; e.g. on Wall Street, its common to talk about risk management, volatility & risk even if there are many interpretations of these words.
do you understand the difference between volatility & risks ..?
if you don’t like to take risks in everyday life, don’t get out of the bed because every action that you take in life has a reaction (according to Newton) and some risk (according to VIP)
volatility is like a ride on a roller coaster (think Santa Cruz boardwalk, six flags mountains etc.) … when you are riding on a “roller coaster”, you will be swinging up & down … that’s part of the design … what’s important is safely reaching the destination and, of course, having fun during the ride … similarly, swings in major U.S. financial markets are natural, which lead to volatility; however, for an individual, what is important is achieving a goal (like having enough money for retirement) & not worrying about the swings in the journey … the market swings wouldn’t matter if your investment time frame is long (i.e. 5-10 years+) … on the contrary, if you hold your investments in “safe” (less volatile) instruments and can’t achieve your goal (like happy retirement) … it is the most risky scenario.
let’s say we are just starting a journey and are at 0,0 (in the above chart) and in 10 years, you would like to achieve a goal (100% on the chart) … in a perfect world, everything works as planned and expected, and you achieve 10% of the goal each year (blue line) … but we live in a world that’s far from perfect; i.e. volatile … which means in some years you will be above average, while other years will be below average (like investing in stocks) … giving volatility to our accomplishments (as shown in yellow line); however, in 10 years, we still achieve 100% … now there is another scenario where there is no volatility (or it is less volatile than yellow line) meaning not much variation year over year (like holding all your capital in a bank providing fixed/zero returns, as shown in red line) … everything works smoothly like a straight line; however, we only accomplish 50% of the goal in 10 years …
in my opinion, this (red line, no volatility scenario) is a risky scenario, although life would run smooth in this one.
a fine line between risk taking and stupidity …
like many words in English language, risk is over-used and over-hyped, specially in corporate world, and specifically in project management and financial world …
in my opinion, if you don’t have sufficient knowledge about something because you have mental limitations; or can’t handle a task because you are lazy; or as you may not know the consequences of an action; or if you have other limitations possibly imposed by others, but still end up pursuing the task, it is stupidity [or crazy as the case may be] and not risk taking …
i had tough time working with “project managers” on this very topic during my corporate life … for example, if there is no one in a team who knows how to develop a piece of software or if the management is yet to hire a key position for a project & you are unable to, then a typical project manager would call these as risks, while i call it suicide mission … the project manager will start a project .. on-time .. check … prepare a weekly report .. on-time .. check … and will put 30 risks in her report to CYA & to show that her tasks are done … with known deficiencies which ill possibly be resolved during the life of the project (if senior management allows them) but with loss of time & when the project / milestone is not delivered on-time, she will be happy to bring this risk sheet and say yes, the risk is realized …& i would say, don’t you want to hang yourself at this moment … because it was plain stupidity to start a project in such a situations … since the office environment is political, these deficiencies are called as risks … why even start a project, if you don’t meet the key conditions ..? .. i guess the top management just want to put a tick mark that something has been started so it becomes someone else’ problem … and you wonder where does the politics start in an organization … these “known deficiencies” are facts, which are known to everyone from the board [of management] down that the project is running on God willing basis … and if something is known to everyone as a fact and we all accept it, then how can such a thing be termed as risky … and you know the most funny situation in my life has been when a project manager calls for a meeting on the topic to ask, let’s categories these known deficiencies as high/medium/low & assign some probabilities … and i used to say, what the f..!
second, taking an action without understanding its consequences is risky … i hate people, when they say i didn’t know the consequences [of my action] … in fact, this is the proper definition of Karma .. see “About/The Human Mind and Body” page for details ... and since someone took the action in past anyway, somehow they are not accountable … because of such a thought process, corporate life is mostly about internal problem solving or fixing someone else’ f*ups … you don’t want such people on your team … OTOH, you want to work with people those who are not only willing to work/deal with unknowns, but also don’t leave the battle, when the odds turn against them.
Graham & Buffett used a term as “margin of safety” to define risks … again, let me use an example to explain margin of safety, if you are walking on a sea shore, enjoying the wind while looking at the view from a cliff (my favorite activity & favorite locations are Half moon beach & Sunset beach on Hwy 1 in CA) … does it really matter whether you are walking one feet or 10 feet away from the cliff ? … may be it does to some people … but to me, the 10 feet provides a huge margin of safety without compromising the view … of course, the wind you enjoy is pretty much the same … in my opinion, walking within one feet of the cliff will be stupidity, although some will call it risk taking … as staying just a few extra feet away provides a huge margin of safety while enjoying same returns (the view and the wind in this case ..!)
i completely disagree with Wall Street’s notion of higher risks means higher reward .. if this was true, Buffett would not be the richest investor in the world …!
let me summarize all the above using simple math & logic:
IF (you don’t know the odds of an event happening in future) {
IF (you put no effort in learning further about it before taking an action) then
it is ignorance or laziness or simply idiotic;
ELSE IF ((no one else around you know either since it is a brand new concept) &
(you are experimenting to know it better)) then it is risk-taking;
// venturing in an entrepreneurial context
} ELSE { // i.e. you do know the odds
IF (the odds are close to 50% like 40-60%) then it’s simply trying luck;
// ex: tossing a coin or options trading
ELSE IF (the odds are low like 10-20%) then it is stupidity; // ex: gambling
ELSE IF (the odds are extremely low like one in millions) then it is madness; // ex: playing lottery
ELSE IF (the odds are much higher than 70%) then it is execution with confidence;
// & there is a good chance you will win but
// you got to continue trying and
// that’s where persistence comes in.
}
It is stupidity and not risk taking when you know that the path or end is bad …
but take the action anyway, assuming it will be taken care of somehow [By God or some super power]
- spending beyond your budget [and if you don’t have a budget in first place, you may skip rest of the list ..!]
- taking a mortgage or loan you can’t afford to pay
- getting a new loan to pay an old loan (also known as ponzi scheme)
- buying stocks (or any asset) on margin (beyond the cash in your account) and without a clear plan on when to sell
- start buying stocks when everyone in the neighborhood and office is trading and talking the stories of getting rich overnight
- using leverage, specially when you don’t understand its downside (interestingly, everyone understands the upside ..!)
- thinking options can provide higher returns on investment capital (money available in your investment / trading account) than the underlying asset (e.g. stocks)
- starting a business with your brother in law when neither he nor you have a clue
- going into a business when someone who thinks he has the greatest idea ever to become rich, and all he needs is some money
- participating in a 50-50 partnership [because the relationship needs balancing every day]
- when individuals (or countries) consume more than they produce
- drink & drive
the theme here is that taking debt/using leverage that you can’t handle or when you are doing something without a clue / God willing basis is risk taking.
risk & its management
as a trader, you will be predicting the outcome of a future event (earnings, unemployment, etc.) using statistical models … let’s say your time frame is next three months … and of course no one can predict the future … but you do it (based on your model) because that’s your competitive advantage … you predict a set of values based on various scenarios (not by borrowing from other mortals or some websites ..!) … and based on those predictions, you put your money … and if the reality doesn’t match with prediction (as the reality is revealed in due course of time), then deal with the situation … i.e. if you screw up, then accept accountability & fix the situation … that’s how i define as risk and its management … btw, this is what i do … everyday in my life now … and if you can’t handle this, then trading is not your cup of tea ..!
risks management is dealing with uncertainly [when predicting the future; i.e. dealing with something you just don’t know [vs when you may not know], and you still need to take an action because the cost of avoidance is way too high … in the financial world, people say stocks are risky … first, stocks are not risky, they are volatile (hope you know the difference by now!) … and if you are unable to handle the volatility and end up working in your 70s & 80s because you do not having have enough funds for your retirement … now that’s damn risky … you will end up in this situation mainly because you didn’t take an action of learning & saving & investing (in stocks), when you had the opportunity.
diversification: wall street advises you to diversify to minimize the risks … so, if one or more investments go down, you are saved as the others are still standing … but have you asked your broker/adviser, why some of them did go down, as he/she is the one who selected them in the first place ..? … you will never find an answer to this question.
diversification is good but only when things are independent … bundling look-alike securities (like wall street did with sub-prime loans) can’t turn them into good … can mixing two sour drinks turn into a sweet one ..? further, diversification in uncorrelated assets is good, but over-diversification in related assets not only reduces volatility, but also reduces your returns, and doesn’t eliminate market risks …
risks & rewards: one other fallacy that is commonly sold by wall street is that risks and rewards are correlated i.e. investors need to take higher risks to get higher reward/returns … nothing can be far from truth … Graham & Buffett used the concept of margin of safety to explain that lower risks provide higher the returns … let’s use the same example mentioned above as walking along the cliff … it is not that the wind is different within ten feet of the cliff, but the chances of falling into the creek go down .. way down .. which gives you higher chances of survival in life (and better returns in investments) … remember, for any loss in an investment, you have to make equal gains just to break-even, and in terms of %, you need to make double just to break even … i.e. if you lose 50% of the capital, you need to gain 100% (from 50% down) just to break-even … now, think why Warren Buffett is the richest investor in the world ..?
real risks can not be eliminated: if you drive a car on the road, you face certain odds of getting into an accident … can anyone predict and save you from a car accident that will occur in future ..? the answer is NO … the most you can do is follow safe driving practices and be ready to face the odds of getting into one … that’s why you buy insurance … guess what, it is not always your fault that you are involved in an accident … further, in an accident, whether you are involved or not, everybody on the road is impacted … similarly, if banks provide easy financing and folks can’t make the installments, resulting into mass foreclosures, taking markets down … everybody is impacted …
now, think about how [successful] insurance companies make billions of dollars taking the other side of the “risky trade ..!” (when you buy your car insurance) … Buffett uses float from his insurance companies for equity investments … where is the “risk management” in those investments ..? he doesn’t need one because he & Ajit Jain know the odds of losing money in any scenario more than anyone on this planet.
conclusion: learn what you do not know, and deal using probability & experience (historical data) with what you can not know, but do know that mixing related or unrelated things – also known as diversification – does not improve your odds of success, it simply protects you against your stupidities, but result into reducing your returns.
however, this doesn’t mean that you should invest in stock market blindly anytime … your returns will depend upon the price you pay and the time you enter the market.
in closing, if you read the whole thing, you know that i am passionate about this topic, and like everything else, i have different views on this one as well … moreover, in my opinion, understanding & dealing with [real] risks is what differentiates between success & failure in investing ..!