Recently, I read the book called ‘The End of Alchemy: Money, Banking, and the Future of the Global Economy’ by Mervyn King who makes some great points about how our financial system is based on Alchemy (Banks creating money out of thin air) and deeply flawed in the way it’s incentivising individuals working in it. Great book, a bit dry here and there.
That put aside, one point that really stuck with me is how the behaviour of households is explained by the notion of uncertainty. Surely, having sat through economy classes in uni, I knew that in economic theory individuals assess future events by their probability and their potential impact on their well-being, or the so-called “utility.” Therefore, they always do what’s rationally best: to optimize that “utility.”
To give an example, let’s say that despite great news about vaccine efficiencies, you’re very certain that we won’t get around further time of social distancing and staying at home. Therefore, you believe that shares of tech companies will continue rising in value, and might use the dip they’ve experienced to buy even more. *Do not take this as investment advice btw.
Unfortunately, it is not that easy to assess each possible outcome as some things about the future, we simply do not know. Could our ancestors possibly have known, that one day we would produce energy from solar panels or trash the planet with plastic? Certainly not. What they had an idea about was the risk of drowning when swimming through a river and the dangers of wild animals.
While some confuse risk and uncertainty, certain factors are differentiating them and understanding both can help in decision making. So let’s start with risk.
According to the Cambridge dictionary risk is “the possibility of something bad happening.” When it comes to trading and investing, risk is related to return and the chance that the actual results differ from the expected outcome. The biggest risk when investing is, to lose all the money invested (possibly more if you trade with leverage). When traders take big risks in their trading such as trading with a lot of leverage, they expect bigger returns to make up for the risk.
The beauty of risk is, that it can be measured and quantified (Knight 1921). As probabilities of a risk to come true are known you can decide for yourself, which risk you might want to tackle and which one is irrelevant to you.
What to do about risk?
In finance as well as in other parts of life, you can deal with risk in different ways. Bear in mind that in the world of business, risks can also be positive. For a company, the “risk” that their target-demographic is growing, might be one to exploit.
Nevertheless, in this post, we will focus on negative risks. To manage negative risk, you have various options
- Avoid — This one is easy. If you know that a certain activity carries a risk that you are not willing to take, then simply don’t partake in it. Don’t want to lose money in trading? Don’t trade. Don’t want to get rejected? Never ask him/her out.
- Retain — Some risks are identified and can’t be avoided. In that case, one strategy is to retain the risk by preparing to cover for the assumed losses. A company can create internal insurance to retain some of the risks that are either too small — making buying actual insurance too expensive — or associated with quantifiable and predictable losses. If you are the owner of a small shop and there is significant rain predicted, you might want to put some money aside to cover for water damage, as getting your store insured against it might look too expensive for small damage.
- Share — If you are receiving employer-based benefits such as private health insurance or dental care, you are part of risk-sharing. Instead of paying the full premium, your company pays part of it. In return, risk is shared with the company and all participating employees. The more people participate, the more the premium should decrease in cost. When it comes to investing, one way of sharing your risk is to diversify your portfolio. By not putting all your eggs int one basket, you reduce the risk of losing it all with just one investment and you have the chance that one well-performing asset in your portfolio makes up for others’ losses (these days bitcoin or tesla could do).
- Transfer — What would insurance be without risk transfer? Probably non-existent as their whole business model is taking on other peoples or organizations risk. Individuals who want to insure themselves against losses when losing their job can buy unemployment insurance while businesses that deem it a feasible risk to be sued can get legal protection insurance. In either case, the risks are transferred to a different party — the insurance — and when a job is lost or the company sued, the insurance will cover losses. Funny enough, insurances also get insured furtherly by re-insurance companies. Probably those get insured as well by re-re-insurance companies and at some point, it’s all traded with an AA rating. Or is that being a cynic?
- Prevention and reduction — There is one obvious example these days for this one. Want to prevent or reduce the risk of contracting corona, wear a mask, keep your distance from others, avoid places with poor ventilation, wash your hands, take vitamin D and what not. All these are steps you can take to reduce the risk of contracting the virus. If you can entirely prevent it from happening, only the stars can tell. Similarly, some health insurances offer their members free health-check ups as well as rebates for gym memberships to prevent the risk of them getting serious diseases that would cost the insurance a lot of money.
All in all, risk is something familiar to us and you can deploy several strategies to make the most out of it (or the least in this regard ;)) For some more details on how to manage risk when trading, check out my article about it here.
In contrast to that stands uncertainty.
“If there’s one thing that’s certain in business, it’s uncertainty.” Stephen Covey
I’d go even further and say that uncertainty is part of our lives. These days it might be more pronounced than before, but it’s always been there. Despite great news of efficient vaccines, a lot remains uncertain. When will they be so widely available that we can go back to our normal ways? Do we even want to get back to the previous way of doing things? Keyword: green recovery.
When it comes to making monetary bets on the future we tend to prefer options with known risks to uncertain options. In 1961 the economist Daniel Ellsberg came up with a gamble that involved picking between which urn to draw a ball from to win. The first urn contained 50 red and 50 black balls while the second contained an unknown mix. Which one would you pick if, let’s say a red one would get you $50? Most people chose the first one.
On a deeper level, we humans have quite a tough time dealing with uncertainty, because our brains are wired to equal it with danger. Many of us might have felt wired or “at the edge,” anxious during the first few weeks of lockdowns and maybe still are. One reason for that is uncertainty puts our brain into a liquid state, that allows it to transition quickly to different configurations to adapt to whatever comes your way. Whenever we feel uncertain we evolutionary want to get back to safety. It can be an extremely stressful state to be in sometimes even worse than knowing something painful will happen.
One experiment conducted by researchers in 2016 in London illustrates this quite vividly. Participants were divided into two groups. One group was told that they would receive an electric shock, while participants in the second group were told that they would “probably” receive a painful electric shock. You might be surprised to learn that, the individuals that knew they were going to get an electric shock were less agitated and calmer than the ones who would might not even get an electric shock (de Berker, Rutledge et al. 2016).
Fortunately for us, we do have some control over our perspective during these times. To just mention a few things we can do to deal a bit better with uncertainty.
- Focus on what you can control —what’s the point of worrying about things out of your control anyway? If there is nothing you can do about a certain situation, concentrate on things that are under your control. Part of that could be developing new routines for yourself and keeping yourself accountable. For example, something simple as going for a 15-minute walk during your lunch break. If you stick with it long enough it will turn into a habit and also gives you a sense of control
- Practice mindfulness — actively and intentionally practising awareness will help you deal better with negative thoughts and staying grounded
- Avoid temporary distractions — emotional eating, drinking excessively or online shopping appear as tempting coping mechanisms, but they are nothing but a distraction from your feelings and won’t help you nor your wallet/health in the long run.
So after covering the psychological part of it, what happens with financial markets when uncertainty grows and what can investors do to be in a good spot?
Uncertainty and Investing
As noted previously, uncertainty is inherent in all markets. With any investment, there will always be some sort of time-lag between the time you invest until it creates a return on investment. This can be hours or years. When investing in assets such as equity many events surrounding the company can impact future outcomes such as a rise in prices of input factors, competition or market conditions, but it’s unclear if and when those events will happen.
When bigger threats to the whole economy such as recession lure traditionally institutional investors will pull out money from equity and invest in safer assets such as government bonds or precious metals instead. These assets won’t make a big return, but they are known for being stable and a safe bet. Sometimes when uncertainty is rising companies of non-essential items experience a sell-off. Quite the opposite applies to essentials. If one of the big oil-producing countries went to war, a rush on oil would follow suit driving up prices.
However, great uncertainty also brings a lot of opportunity for investors that are at the right time investing in the right asset or who figure out which sectors will benefit from it. Take bitcoin for example. While some had already written it off as a scam that isn’t performing, it has proven all those folks wrong and experienced a bull-run close to the highest value it’s ever been at.
Nevertheless, this is not to say put all your eggs into bitcoin. When investing during uncertain times the basic rules are similar to the traditional rules of investing…
- Have a plan and execute it. Know at which point you cash out returns and how much loss you are willing to take.
- Diversify, diversify, diversify — Across country borders, sectors, asset classes
- Rebalance your portfolio from time to time. As time passes and assets increase and decrease in value, ensure that the proportions are still roughly what you want them to be.
- Invest small amounts regularly. As a lot of underlying bias can influence our investment decisions, investing smaller amounts regularly can help to keep these at bay and avoid investing at the wrong time.
- Consider adding some “safe haven” assets such as gold or government securities to your portfolio to ride out tough market conditions
- And don’t forget to keep a cash-buffer for short-term needs.
To sum it up, risk can be calculated while uncertainty cannot. While you avoid the first, you have to deal with the latter. In life by controlling your perspective and when investing by making smart choices and taking some precautions.