Real Risks

I follow the stock market and so towards the end of each year I come across lots of fairly useless prognostication. The seer – usually a standard issue financial charlatan, but sometimes a person with an actual defensible record and a meaningful framework – usually ends by pointing out risks to the forecast. These are inevitably focused on current hot issues. For example, this year you’d find government risk (what if there’s another insane budget crisis), worry about Fed “tapering”, questions about whether the retail investor will come “off the sidelines” armed with that mythical and meaningless “cash on the sidelines”, and, of course, China (hard landing!?!?!).

What is always missing are the hundreds of reasonable but infrequent and low probability events. Just a few examples include large-scale terrorism, a major war (Japan-China?), a pandemic, a couple of catastrophic natural disasters, large scale electrical disruption from a freak solar storm. You get the picture. Those are real risks. They stack up. And they should remind us why common stocks should receive a healthy discount, since they’re at the bottom of the list as residual claims.

There are, of course, many things that can go well – things that can get better than we thought – and historically many things have. The difference is that the things that get better happen over time and even if they involve positive cascades these processes are inevitably slower.  Most negatives seem like a bolt from the blue or involve very rapid cascades.

There is an analogy to entropy, that mysterious and pervasive concept from thermodynamics. An egg on the edge of a table can become a shattered mess with a wisp of wind, yet reversing the process is beyond the capacity of all the kings horses and all the kings men. Creating order and organization is an energetic endeavor which takes time, but if tiny cracks exist (which surface thermodynamics tells us is an expression of stored energy), then seemingly small shocks may propagate a cascade failure. Similarly, we may admire a painstakingly made, highly ordered object, but if it is situated perilously then external forces can ultimately cause failure. Only by stepping away from the creation and considering it in the context of its environment can we begin to understand the risk (*). Stocks do not exist within financial markets or within a finite set of monitored economic variables. They are tethered to entities subject to the complexity and seeming randomness of the human and natural environment.

* This last point is not “the forest for the trees” lesson, which advises us to see patterns and understand the whole of a system rather than focusing on a single component. This is more of a wrapper around that lesson. We may study the forest, understand it, marvel at its beauty and its intricate ecosystem of fauna and flora. We may worry about a bit less rainfall this year or a handful of poachers, yet still be blind to the dry hot wind blowing or the adjacent steep mountainside soaked wet and filled with boulders or the gathering lightening storm. Or the army of lumberjacks.

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