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.