Investment risk is largely invisible before the fact except perhaps to people with unusual insight and even at er an investment has been exited. For this reason, many of the great financial disasters we’ve seen have been failures to foresee and manage risk. There are several reasons for this.
• Risk exists only in the future, and it’s impossible to know for sure what the future holds. . . . No ambiguity is evident when we view the past. Only the things that happened, happened. But that definiteness doesn’t mean the process that creates outcomes is clear-cut and dependable. Many things could have happened in each case in the past, and the fact that only one did happen understates the variability that existed.
• Decisions whether or not to bear risk are made in contemplation of normal patterns recurring, and they do most of the time. But once in a while, something very different happens. . . .Occasionally, the improbable does occur.
• Projections tend to cluster around historic norms and call for only small changes. . . . The point is, people usually expect the future to be like the past and underestimate the potential for change.
• We hear a lot about “worst-case” projections, but they often turn out not to be negative enough. I tell my father’s story of the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away. Invariably things can get worse than people expect. Maybe “worst-case” means “the worst we’ve seen in the past.” But that doesn’t mean things can’t be worse in the future. In 2007, many people’s worst-case assumptions were exceeded.
• Risk shows up lumpily. If we say “2 percent of mortgages default” each year, and even if that’s true when we look at a multi-year average, an unusual spate of defaults can occur at a point in time, sinking a structured finance vehicle. It’s invariably the case that some investors especially those who employ high leverage will fail to survive at those intervals.
• People overestimate their ability to gauge risk and understand mechanisms they’ve never before seen in operation. In theory, one thing that distinguishes humans from other species is that we can figure out that something’s dangerous without experiencing it. We don’t have to burn ourselves to know we shouldn’t
sit on a hot stove. But in bullish times, people tend not to perform this function. Rather than recognize risk ahead, they tend to overestimate their ability to understand how new financial inventions will work.
• Finally and importantly, most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.
“No Different This Time,” December 17, 2007
Failures to foresee and manage risk!
