“When you change the way you look at things, the things you look at change.” —Max Planck, Nobel Lauriat, Physics 1918

Demystifying Risk...Really?

Can risk and its intricate, multi-dimensional and ever changing nature, actually be demystified?

If that view resonates with you, you’re definitely not alone. Risk is often viewed as a multi-faceted and bewilderingly complex phenomenon. It’s also a commonly held conviction that perplexing, complicated, challenging phenomena like risk must be addressed with complex responses. However, meeting complex issues with complex solutions can often create more confusion than they resolve, not less. That’s exactly what’s happening with our current, unnecessarily technical and overly intricate view of investment risk as well.

Fortunately, the seemingly complicated issues associated with risk can be addressed and resolved by working to simplify the way we look at and deal with risk. Doing so will also help us reduce the uncertainties, fears and the risks investors normally associate with risk management, plus make our risk management efforts more effective.

Once you’ve “demystified” risk in this way, you’ll never look at risk and risk management quite the same way again. In fact, consider the observation of Oliver Wendell Holmes, Sr. on the topic of looking at things in new ways:

“Every now and then a man’s mind is stretched by a new idea, and never shrinks back to its former dimensions”

One of the most powerful examples of the viability of working to de-complicate seemingly bewildering issues is the breakthrough insight of physics genius Albert Einstein. He famously uncovered a basic law of the universe when he demystified and simplified the previously unknown, baffling, and seemingly unrelated relationships between energy, the speed of light, and mass, with his famous equation: E = MC2.  As a result, Einstein said:

“If you can’t explain something simply, you don’t understand it well enough”

As financial advice professionals we have an enormous opportunity to help our clients demystify, simplify and meet their crucial “unmet” need to better understand and manage the full range of uncertainties and risks of our rapidly changing, increasingly less certain world. In fact, author Andrew Zolli, vividly highlights that growing, universal need in his globally published book Resilience—Why things bounce back, when he states…

“In today’s rapidly changing world, even with perfect knowledge, one can’t escape the nagging suspicion we’re ballroom dancing in the middle of a minefield.”

Of course, by helping our clients meet and directly address their critical unmet need to better understand and manage volatility, uncertainty and risk, we’ll also help our businesses, ourselves and our profession in a fundamental and invaluable new way.

 

What would it be like to be a financial planner/advisor who, in addition to our traditional services, could also help clients demystify risk and risk management, plus better understand and manage the risks they face, rather than have risk control them?  

The Enormous Benefits Of Demystifying Risk

You’d help your clients:

You’d help yourself and your business:

Not only would you and your clients enjoy all these valuable benefits, your clients will feel truly indebted to you for your work in helping them meet their life, business and investment goals and helping them navigate the ever evolving risk “minefields” they’ll face along the way.

The Big Question Is…HOW?

How can you actually go about demystifying and better understanding such a multifaceted, complex and often intimidating topic as risk?

To demystify, simplify and change the way you look at and feel about investment risk. All you have to do is just follow the very same steps that were used to successfully demystify historic complex challenges we’ve successfully demystified in the past.

Examples include: Achieving human flight, open heart surgery, the horrors of bacterial infections, the crippling scourge of polio (During the 1950’s people feared polio more than global nuclear war) to humans first landing on the moon and returning to earth safely.

 

Use The Time-Tested Method For ‘Neutralizing’ Almost Any Kind Of Risk

Transform risks that do occur from potential nightmares/disasters and painful negative surprises into mere inconveniences and even potential opportunities, by following this simple and powerful process.

Risks that we’ve…

            with very few exceptions, can be neutralized.

Using this straightforward approach allows anyone to demystify risk and reduce the uncertainty, fear and risk associated with risk management, and to “tilt” the normal risk/reward relationship (Greater rewards requires taking greater risks) to their personal advantage.

Although risk can never be totally eliminated, by identifying the risks involved, fully understanding them and thoroughly preparing for those risks in advance, one can actually tilt the normal risk/reward equation to their benefit by neutralizing and reducing the risks involved relative to the higher returns they’re seeking.

An example of tilting the risk/reward equation to our advantage:

Just think about the enormous inherent risks involved in open-heart surgery. Those risks have been identified, thoroughly understood,and fully prepared for to the point where thousands of such surgeries are now conducted successfully every single day. The risks relative to the benefits have been enormously reduced, resulting in dramatic improvements in the quality of life of patients who’ve undergone this procedure that in the mid-1940s was considered “just too risky” to even attempt.                     

Five Steps To Demystify Risk And Risk Management

1. Understand “Risk Basics” — How risk really works — What’s actually going on?             

2. Conduct and utilize personal risk assessments

a.     Identify risk

b.     Understand risk

c.      Prioritize risk

3. Prepare and plan for risk in advance

4. Utilize effective ongoing risk monitoring and risk decision making

5. Continuously learn and adapt (based on your actual experiences)

Special Note: For this discussion we’ll focus on the first two points since they directly address the demystification of risk. Points 3-5 which are focused on the demystification of risk management, will be addressed in a follow-up article.

 

Prior to reviewing the specifics of these steps, it’s extremely important to step back and review some basic characteristics about the true nature of risk. These characteristics aren’t always obvious, however they are key to demystifying and simplifying risk, and to better understanding what’s really going on.

1. Understanding “Risk” Basics — How Risk Really Works — What’s Really Going On?

Lessons from Our Risk/Threat Biology

A. Work With…Not Against…The Most Successful Risk Management System Ever

We humans have as standard equipment, hardwired into the very fiber of our being, the most powerful and successful risk/threat management system ever invented. In addition to all its other capabilities, our innate risk management system has the priceless flexibility to learn and adapt to new and evolving risks.

· Unfortunately, animals like squirrels, skunks, cats and dogs that we often see “flattened” by cars, lack our critically important human ability to learn and adapt to the “new” risks posed by the accelerating pace of change of our high-tech, super-connected and interconnected, information overloaded, more complex, increasingly less certain world.   

We have within us the most unbelievably powerful, highly sensitive, unconscious and automatic threat detection, assessment, monitoring and risk response system ever devised. It’s been developed, improved and refined over 100,000 years by the harsh demands and “survival of the fittest” realities of an unforgiving world, that’s always testing us. 

Our risk management and response system includes almost every cell in our bodies from all five of our senses, all our organs, digestive and excretory systems, nervous system, thermoregulation, musculature, hormones, circulatory system, lungs, heart, plus the brain in our head and the even “older brain” in our gut. In addition, almost all of this incredible, fully integrated threat response system operates without us ever even having to think about it.    

As financial advisors, we and our clients simply can’t ignore our incredibly valuable, innate risk management system, not understand its workings, minimize its role/importance or fight against it…otherwise our job will be much more difficult than it needs to be, and our clients will be less well served.

As professionals, not understanding, respecting, working with, and utilizing it will insure that we’ll continue to be frustrated by our clients’ seeming irrational behaviors, self-inflicted risk/reward decision-making errors and our inability to know or understand why.

If, however, we understand how this amazing risk management system works, help our clients to understand it and prepared for its manifestations when investing, we’ll all benefit greatly. By incorporating and preparing for this impressive system’s normal workings in our financial, investment and risk planning, client communications and ongoing risk/reward decision-making processes, we’ll do a much better job for our clients. We’ll build their confidence and trust in both themselves and in us more quickly. We’ll also add exceptional additional value to our professional services, and attract more business more easily, as a result.  

 

B. The ‘Total Body’ Risk Response And Its Priority To ‘Take Action First And Think Second’

· In a natural world environment, when our innate risk/threat response system is activated, our bodies freeze first to asses the immediate threat and see if it passes. If not, it then moves to “taking action” with the flight response, and finally, if flight isn’t effective to use fighting as a last resort.

· In the non-natural world of investing, although the biological freeze, flight, fight reaction may be triggered by market downdrafts, it’s important for long-term investors to be mindful that periodic temporary market downturns are normal and to be expected. It’s critical that they learn to place their “real world,” powerful, full body, biological freeze, flight, fight responses in perspective. By preparing for and then resisting the normal and natural emotional drive to take action first when operating in the volatile, non-natural world of investment markets, we can help our investors learn to avoid taking such actions that are counter to their own best interests.

C. Understand And Avoid Our Costly ‘Risk/Reality Perception Gaps’

·  Behavioral scientists have demonstrated a curious, universal human trait of people worldwide (regardless of culture, race or gender) to perceive many risks as greater or less than they actually are.  Which can frequently and unknowingly contribute to flawed risk/reward decision-making.

·  Although there are more than 20 of these risk misperceptions documented, it’s important that we help investors recognize and avoid those risk misperceptions that have the greatest potential negative impact on investment decision making. Reacting to the following four situations where behavioral scientists have proven that we humans incorrectly perceive risks as much greater than they actually are is especially problematic for investors.
 

Situations Where Risk Is Perceived to Be Much Greater Than Reality:

1. Large-scale consequences                              
2. New, unfamiliar, not understood
3. Beyond our perceived control/influence   
4. Not expected or occurs\ suddenly

These extreme risk misperception situations are particularly problematic in investing. Not only can any one of them generate a perception of greater risk than reality, all four of them can and have occurred simultaneously within a single trading day. In such simultaneous cases, investors’ misperception of risk can literally “shoot through the roof.” The most effective way to neutralize the negative consequences of acting on these extreme risk misperceptions is identifying, understanding and preparing for them in advance.

 

2. Identify Risks

A. Recognize And Understand The Many Uses For The Word Risk.

This point is important, because the term “risk” can carry many different meanings depending on how it is used. If not directly addressed early in your relationship, any mix-up in meanings can lead to serious miscommunication issues. It’s also important to be certain you’re focusing on the risks themselves, not the results of risks. 

Here are a few examples of the multiple meanings of the word risk, as articulated by risk communications experts Paul Slovic and Elke U. Weber in their 2002 paper “Perceptions of Risk Posed by Extreme Events”:

   Risk as a hazard…Which risks should we rank? 

   Risk as a probability…What’s the risk of getting AIDS from a contaminated needle?

   Risk as a consequence…What is the risk of letting your parking meter expire?

   Risk as a potential adversity or threat…How great is the risk of riding a motorcycle?
 

B.  Use An Empowering Definition Of Risk, Rather Than A Restrictive Definition.

No single element of advisor/client communications is more important than being certain that you, your clients and potential clients are in complete agreement on your shared definition of the term risk. When it comes to risk, the basic definition one uses is also the critical foundation on which our entire risk management approach is built.

Our definitions of things are the frames through which we describe, understand and view them.

With a solid, empowering definition as your foundation, what you build will make the job of risk management for you and your clients easier and more effective. It will also serve you and your clients better, and stand the test of time.

With a weak or restrictive definition, even the grandest, most sophisticated risk management methodologies will be compromised, leading to frustration, disappointment and negative surprises. 

 

Many financial planners and investors use one or more of the following definitions of risk:

How Do These Definitions Make You Feel About Your Ability To Deal With Risk?

Do they empower you, make your job easier,and give you and your risk management abilities a better sense of control? Or do they make you feel that you have little or no ability to manage such phenomena?

These definitions of risk may not empower us because they describe the results of risk versus defining them. Volatility, loss, variations in returns, negative surprises, harm and negative consequences don’t happen in a vacuum. Something causes them, so they become secondary, or in some cases, even tertiary results of actual risks manifesting themselves.

Medical students learn early in their professional training the critical importance of treating the underlying disease rather than the symptoms. 

As financial planners we need to focus first on the risks themselves, not the results of the risks. We must first identify the risks, then successfully avoid, prepare for, neutralize or manage the risks so the results of those risks occurring are either prevented from occurring or dramatically reduced.

A truly empowering, practical definition of risk comes not from the investment world, but from Peter Oppenheimer, former chief financial officer, and one-time chief risk officer of Apple,Inc.:

“The degree to which an outcome varies from our expectations”

 


Consider this simple definition’s far-reaching and positive implications:

It’s an empowering definition, because although we have little or no control over the future, we alone have total control over the full range of our expectations of potential outcomes—both good and bad.

When we know, understand, and are prepared for risks, the very nature of that understanding and preparation can neutralize risks that do occur, and convert them from possible nightmares into minor inconveniences, and even potential opportunities.

 

C. Be Sure You And Your Clients Agree on the Same Empowering Definition of Risk.

Clear, open and unambiguous communications between a planner and every client is critical to maximizing the effectiveness, value and ultimate success of a planner’s advice. No single element of planner/client communications is more important than being certain that you, your clients and potential clients are in complete agreement on your shared definition of risk. 

So in the early interactions you have with clients and prospective clients, remember to ask them their definition of risk. If they’re using a restrictive or limiting definition, then share with them the empowering definition you prefer to use below, as well as its many benefits reviewed previously. 

Risk: “The degree to which an outcome varies from our expectations.”

Then mention how important it is to clear communications and effective risk management that you both share the same definition for a term that’s so fundamental to investing, and ask them if they like your empowering definition of risk better than the definition they first mentioned. If so, then confirm with them that your definition will be the definition you’ll both be using for the term risk in all your communications and interactions with one another.   

D. What Generates or Causes Risk To Occur?

At its most fundamental level, risk—or the inherent potential for things to break down, fail, not work or deteriorate is the result of one of the most fundamental of all the natural laws of the universe. As specified by the second law of thermodynamics, entropy is the basic natural characteristic of everything in the universe to move from order to disorder and randomness or from a higher level of energy to a lower level of energy, unless external energy is expended to maintain that order.

The increasing randomization of energy, entropy, is part of the basic structure of the universe. Entropy is why broken windows don’t fix themselves, why heat flows from a hot object to a cold object and not the other way around, why sugar and salt crystals dissolve in water and don’t un-dissolve. It’s also why paint eventually peels and degrades, and iron rusts.

Bridges and building will eventually collapse unless entropy is countered by the addition of new energy, money, power or labor into the system. Its also why, as we know so well, that money has a strong tendency to dissipate, and randomize. Entropy is why businesses fail, and investments don’t maintain exceptional performance indefinitely. They have a tendency to sour unless we enhance success by inserting additional energy in the form of new strategies, research work, new people, new management or injecting further capital into the business, etc. The second law of thermodynamics decrees “that anything that can go wrong not only will go wrong, it must go wrong.” (We just don’t know when.)

 

Risks transition from potential risks to become active risks when the status quo, current situation or general state of something change. The more rapidly any of those change takes place, and the more widespread their effect, the greater the impact of active risks become.

Since we now live in the most rapidly changing period in human history, on all fronts (technology, science, medical, social mores, communications, transportation, interconnectivity, economic, gender identity, definition of family, information, etc.), and our increasing pace of change is likely to continues accelerating into the future. As a result, we’re now seeing things that aren’t supposed to happen beginning to happen more and more frequently.

The accelerating pace of worldwide change, and increasing interconnectedness of the world, insures we’re going to see more and bigger risks, and more and bigger opportunities hurtling toward us faster and faster in the future. Recent examples include the 2008 global financial crisis, the BP oil spill, JP Morgan “London Whale” multi-billion trading losses, the Asian tsunami and Fukushima disaster of December 2004, Toyota’s unintended acceleration scandal, Takata airbag scandal, Volkswagen emissions control computer scandal, The Arab Spring and BREXIT.

Our traditional ways of dealing with risk in indirect, passive, situational and/or reactive ways just don’t work as well as they used to. We’ve crossed a critical inflection point where what’s now needed in our rapidly changing, less certain, higher volatility world is that we address risk in a new, direct, proactive, and comprehensive way. A method that’s based on a deep knowledge and thorough understanding of the true nature of risks, and full commitment to advance preparation for the risks we all face. 

We know that risks will occur, we just don’t know when. Therefore, we have the choice to directly and actively manage the risks we all face or suffer the consequences of those risks controlling us. It’s just the manifestation of the classic requirement of the second law of thermodynamics (entropy) we reviewed earlier. To avoid things breaking down, not working or risks controlling us, we must invest additional work, energy, effort and preparation into the system.

E. Recognize, Understand And Prepare For The Two Broadest Categories Of Risk?

External Risks:

Although when we think about risk we almost always focus our attention on all types of “External Risk(s)” There’s another high level category of Risk that we talk about a great deal, but don’t actually do much about.

Internal Risks:

This especially insidious form of risk can cause us as much or even more harm, and it needs a great deal more attention… That category is internal risk or risk/reward decision-making risk. It’s an especially challenging form of risk because of the many behavioral biases, heuristics, perception reality gaps, assumptions, misperceptions and ingrained decision-making flaws we all naturally carry with us. Although it should be more preventable, these missteps can be especially problematic because our innate “brain bugs” make it extremely easy to unconsciously act against our own best interests.

 

F. Understand the Three States of Risk.

Although we generally think of risk or uncertainty as a single, multifaceted phenomenon, according to Professor Benoit Mandelbrot in his book, The (Mis)Behavior of Markets (2004), the “true” nature of risk is actually less intricate than that.

The real beauty and power of his breakthrough observation is that it makes what we see actually happening in the real world more understandable and clearer. That deeper and less complicated understanding of risk then makes the management of risk easier and more effective.

After many decades of studying uncertainty in many different markets, Dr. Mandelbrot (who’s also renowned for inventing the newest form of geometry, fractal geometry) observed that uncertainty (risk) comes in more that one form. In fact he came to the realization that instead of having only one form, uncertainty actually has three primary forms or “states.”

Initially that concept may be a little hard to grasp. However, multiple states or forms are a quite common phenomenon in the natural world. A tangible example of this characteristic is the very physical matter that composes the entire universe.

At a fundamental level, all matter has three basic states: gas, liquid and solid. Just as water has three distinct states: ice, liquid water and gas (steam), with each state exhibiting very different physical properties and behavioral characteristics from one another.

Dr. Mandelbrot has identified three different states of uncertainty/risk. Each of these states exhibits properties and characteristics as different from one another as ice, liquid water and steam are from each other, even though they are all H2O. These three states of risk are mild, slow and wild uncertainty

Mild uncertainty is like the risk in calling a series of coin tosses. This form of risk/uncertainty adheres to the normal bell curve distribution. It has well defined parameters, low volatility, no big surprises and is predictable. It’s like the solid state of matter because it has low energy, and stays where you put it. It’s the kind of risk, price variability and volatility that are found in normal, random walk stock market periods. As author NassimTaleb says in his book The Black Swan…This type of risk is characterized by the routine, the  obvious, and the predicted.

Wild uncertainty is the opposite of the mild form. It s unpredictable, irregular, outside what is normally expected, high energy, nor structured, and has fast seemingly limitless fluctuations from one value to the next. Professor Mandelbrot states, “Its like the gaseous phase of matter, no structure, no volume, no telling what it will do.” This form of risk is typical of extreme, highly unstable, hyper-volatile stock markets like the one in the fall of 2008. Nassim Taleb in The Black Swan provides examples of this type of randomness as the enormous range of wealth, personal incomes, book sales, name recognition as a celebrity, damage done by earthquakes, deaths in war, death in terrorist incidents, financial markets, commodity markets, and inflation rates. This type of risk is subject to the unseen, the unpredicted, surprises and he extreme.

 Slow uncertainty is the form of risk between mild and wild. Dr. Mandelbrot describes it as like the liquid state of matter.

Understanding these three states of risk, and each of their different behavioral characteristics makes it easier and simpler to determine and apply the most effective risk-management methodologies for each one.

 

3. Understanding Risk

Because every risk is different for every individual, a critical element in demystifying risk is knowing and understanding the four characteristics of a risk that must be considered to manage risk:
 

Exposure/Context: Will the individual and/or investment approach/investment vehicle/portfolio be exposed to a given risk, and if so, what level of exposure do they have?

(We don’t need to be concerned with risks we’re not exposed to.)

Likelihood: What is the likelihood/probability of the risk occurring?

Impact: Should a given risk occur, what impact (short, mid and long-term) will it have on the individual and/or investment approach/investment vehicle or portfolio?

Resilience: Should risk occur, what’s your ability or what resources do you have available to help bounce back and/or recover from its impact over the short, intermediate and longer term?

Of all the factors above, which is the most important?  (For the answer…See the next section)

4. Prioritizing Risk:

Which Risks to Avoid, Accept And Manage Or Accept Outright

Since managing risk has a cost (in time, money, attention or other resources) and you can’t protect against everything (since doing so reduces your risk as well as your potential upside), it’s critical to prioritize your risk management resources and attention, and focus on your highest priority risks.

Financial planning practitioners and investors can unknowingly act against their own best interests by giving their highest risk management priorities to the likeliest risks. Although it seems logical to tackle the risks that show up so frequently, and it’s gratifying to swat down some of those nuisance risks (like volatility), it’s actually a trap. Dealing with frequent, low-impact risks can consume valuable risk management time and resources, leaving us even more vulnerable to infrequent—and more harmful—high-impact risks.

Placing a priority on addressing high-impact risks, even if they’re unlikely, can pay off big time. When those low-probability, high-impact risks come out of the blue and devastate those not prepared for them, being ready for them in advance can save much heartache, not to mention     many dollars.

The most effective method of prioritizing risks is to focus on impact first and likelihood second.

In descending order from the most important to the least important, here is an example of how various risk impact and risk likelihood combinations should be prioritized.

  1. High impact/high probability

  2. High impact/moderate probability

  3. High impact/low probability 

  4. Moderate impact/high probability

  5. Moderate impact/moderate probability

  6. Moderate impact/low probability 

  7. Low impact/high probability 

  8. Low impact/moderate probability

  9. Low impact/low probability

This ranking system has proven its effectiveness in determining which risks to avoid, accept and manage, and accept outright across the full range of human endeavors from science, medicine, aviation, construction and farming, all the way to firefighting, police work, childcare, film making and sports. Where this methodology really shines is in how it can adapt to each client’s or each portfolio’s specific investment purposes and priorities. 

 

The Opportunity Of A Lifetime

As financial advice professionals, we derive a great deal of professional and personal satisfaction and pleasure from genuinely helping our clients meet their needs, maximize their resources and successfully achieve their long-term financial goals.

With that thought in mind, there’s currently a uniquely attractive, worldwide unmet client need that’s emerged over the last 15 years that you can meet and benefit from.

This global unmet need represents a true opportunity of a lifetime for financial planners and advisors who first recognize it, and are then willing to be among the first to step-up and help clients meet their critical need to better understand, demystify and manage uncertainty, volatility, risk in a user-friendly way. Doing so has the additional advantage of transforming elevated investor concerns about instability, uncertainty, volatility and risk from business impediments and frustration into powerful business building forces.

With the uncomfortable feeling of people around the world running rampant that we and our world are speeding off into the future like an “unguided missile” with more speed than control, the opportunity to help investors better understand, demystify and deal with uncertainty and risk has never been greater.

Hopefully, this review has helped you appreciate the fact that better understanding and demystifying risk is easier that you may have thought. In addition, I hope it stimulated your interest in learning more about how you can help your clients, yourself and your business by better understanding and managing the ever-evolving risks of our increasingly less certain world.

Michael T. Carpenter is a 35-plus year veteran of the investment business and the founder of CarpenterAssociates, a Boston-based strategy, sales, marketing, professional development and risk management consulting firm. Carpenter is the author of The Risk-Wise Investor: How to Better Understand and Manage Risk.