Seeing The Real Risk

I’m going to make you an offer on your IRA.  We’ll use half a pair of honest dice – one die.  If you roll it and it comes up one through five, I’ll add 50% to your current IRA balance – if you have $100,000 and win, you’ll wind up with $150,000!  However, if it comes up with a six, I win your IRA.  How about it?  If you roll the dice six times the expected average return is a gain of 25%, but that average return distorts the risk of the situation because there is a 16.7% chance that you’ll roll a six on that first try. If you roll a six on the first try, you lose everything; game over.

Investing can also distort the true risk of loss. Suppose there is a 90% chance that an investment will produce a 10% return each year for the next five years – those are pretty good odds – but perhaps the more important question is how much can you lose if that 1 in 10 chance happens?  If the loss is 20% and it occurs in your first year, the actual annualized 5-year gain is 3.2%, even though four out of five years produced 10% returns. 

I used 20% because a 20% loss is the definition of a bear stock market, but that’s the starting point and not the limit of a bear market loss. In the last bear, market many stock indexes dropped over 50%!   Even if there had been a 90% chance that an investment would return an amazing 19% a year for the next five years, if the first year suffered a 50% decline you’d still have a loss at the end of the five years.

A bigger problem with having the boldness to say there is a 90% chance of a gain or that the maximum loss is 50% is that those statements are based on the results of models that like to pretend that finance is the same as physics.  But finance ain’t!  Although financial consequences are the result of cause-and-effect, the relationship is not linear and can be completely disrupted by outliers (occurrences with a very small probability of occurrence) that are either unpredicted or are completely ignored because the odds of the nasty event happening are so low.

The belief in 2006 was that there would never be a mortgage bond default crisis because the mortgage bond quantitative model showed the odds of this happening were too remote.  What they should have done was shut off their computers and asked “what if?”  Our model says that the possibility that 100% of our “AAA” rated bond portfolio going into default is very remote, but what if it did happen multiple times and what if these defaults forced one of the largest investment banks on the planet out of business?  Could that scenario result in an international banking crisis, and if so, how would that affect the perception of other good quality bonds and the ability of homeowners to borrow?  And the answer is: Lehman Brothers did fail and the world narrowly avoided a global depression.

The problem with investments is that it’s impossible to create finite linear math models that can predict the unpredictable.  What that means is to truly understand the risks, sometimes you need to throw away the spreadsheets, the charts, and the purported “odds” and simply ask, “what if?”  You may decide to go in a completely different direction.

This article was written by:
Dr. Jack Marrion
Dr. Marrion is the founder of SafeMoneyPlaces.com. His research on senior decision making and the financial world have been featured in hundreds of publications​.​

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