Living with risks in a random world

26 Nov 2012 08:40 TEH HOOI LING

“Life cannot be calculated. That’s the big mistake our civilisation made. We never accepted that randomness is not a mistake in the equation – it is part of the equation,” says British writer Jeanette Winterson.

Nassim Taleb is another one of my favourite authors. I was struck by how many truths there were in Fooled By Randomness: The Hidden Role Of Chance In Life And In The Markets when I first read it a few years ago.

He followed that up with The Black Swan: The Impact Of The Highly Improbable, which presciently was published in 2007 – just before the global financial crisis erupted. His latest book, Antifragile: Things That Gain From Disorder, is about how stability engenders a false sense of security – one of the things we talked about last week.

Yes, there are loads of randomness and hence risks out there.
Goldman Sachs’ latest shrewd investment was in sandbags and back-up electricity generators. As Hurricane Sandy approached New York, the bags were stacked around its headquarters. It was one of the few offices in downtown Manhattan to remain dry and well-illuminated as the “Frankenstorm” battered the city, reported The Economist.

In contrast, a block farther down West Street, the headquarters of Verizon was awash with salty flood water, soaking cables delivering phone and Internet services to millions of customers. The firm was able to re-route much of the traffic through other parts of its network, but local service was disrupted.

Last year’s Japanese tsunami reminded many companies that moving to “just-in-time” manufacturing through global supply chains can bring new risks. American carmakers found that they could not get essential parts made in Japan. Floods in Thailand last year caused a global shortage of hard-disk drives. It turns out, a large proportion of global supply comes from a rather small area near Bangkok.

The takeaway from the quote, the books and the examples in The Economist article is: We shouldn’t cut things too finely. We shouldn’t bank on things to work perfectly all the time. There should always be a buffer for things to go wrong. And there are always unforeseen things that can happen to mess up our best thought-out plans.

So in this random world, how do we manage our risks?
First, always work with a margin of safety. Yes, it means some wastage. But it’s a necessary cost. Margin of safety is a big concept in value investing. A value fund manager draws this analogy: “It’s like driving on the highway. You keep a safe distance behind the car in front of you. So if anything happens, you have the buffer. You have time to react. That’s margin of safety.” We will talk more about this in a future article.

Two, be prepared for the unexpected. It is a natural human tendency to underestimate the probability of bad things happening to ourselves. Yes, there are precautions we can take. Don’t put oneself in harm’s way. Take good care of one’s health. Still, one can never predict when accidents can happen, or when illness will strike.

Insurance is one way we can protect ourselves financially against such unexpected but “high-impact” events that can result in losing one’s capacity to work and needing to pay significant amounts for medical expenses and so on. So insurance policies are must-haves.

Another form of insurance is what I call social insurance. That is, to build relationships and share our surplus – for we never know when we may fall on hard times and may need the generosity and goodwill of others.

For philosopher Immanuel Kant, this is not a good motivation for sharing. To him, we should do something because we think it is the right thing to do, and not because we want something in return. But hey, we are all so used to incentives. So if anyone needs a reason for sharing his good fortune, this is one way to rationalise it.

Third, don’t put all your eggs in one basket. United States energy giant Enron was a model corporation and darling stock in the 1990s. Many of its employees worked for decades in the company, had their pensions there and invested their savings in its stock. When Enron collapsed in 2001, these employees lost their jobs, their pensions and their savings.

Note that one basket doesn’t just mean one stock or one asset. It could mean a group of baskets that generally suffer the same fate. If you work in the financial sector and invest the bulk of your money in financial stocks even though they are not your own company’s, you are, in a sense, putting many of your eggs in one basket as well.

So to recap, some of the ways to mitigate risks in this highly unpredictable world of ours are: cut yourself some slack, buy yourself some insurance and do not put all your eggs in one basket.
Next week, we will talk about whether high risks necessarily mean high returns.

hooiling@sph.com.sg
One basket doesn’t just mean one stock or one asset. It could mean a group of baskets that generally suffer the same fate. If you work in the financial sector and invest the bulk of your money in financial stocks even though they are not your own company’s, you are, in a sense, putting many of your eggs in one basket as well.

The writer is editor of Executive Money, a weekly section in The Business Times. Her column is also available in BTInvest (www.btinvest.com.sg), a free personal finance and investment site of The Business Times covering five main categories: Personal Finance, Wealth, Markets, Insurance and Property.

Go to BTInvest for expert views on the latest market developments and tips on how to better manage your dollars and cents.