Morningstar Advisor - August/September 2010 - 16

Behavior Gap

Which Risk Are You Managing?
By Carl Richards

The issues of risk and how we talk about “managing” it have caused me a lot of trouble for years. I have never really understood how we can claim to manage risk. It seems to me that risk, by definition, is very hard to control. In my mind, risk is what you have left over after you think you have thought of everything. As I have tried to understand the topic more, I have come up with a few examples that might help clarify the issues, or at least start a healthy discussion.
The Risk of the Mountains

These are things we know that we know. There are known unknowns. That is to say, there are things that we now know we don’t know. But there are also unknown unknowns. These are things we do not know we don’t know.” Think about it for a minute: Here is the man charged with guiding the war efforts during a time of instability arguing that there are risks we know about (those can be managed) and that there is this other category of risks that we don’t know about. In fact, we don’t even know that we don’t know about them.
The Risk of Finance

the real world, there is uncertainty. In fact, the greatest risk to our clients’ portfolios are the things that are left over after we think we have thought of everything. It is often said that the last four words of any great investor are “this time it’s different,” but do we really believe that the limited historical data we have represents a complete set of outcomes? Is there any room for the possibilities of the unknown unknowns? Clients think risk and uncertainty are the same things. When we talk about risk management, they think about risk in general and not as an abstract academic idea. This difference in the way we communicate risk leads clients to expect things that we simply can’t deliver. My point is not that we should run to the hills and grow our own vegetables, nor should we ignore the prudent risk-management tools that we have used in the past. But we need to review the role that uncertainty plays in portfolio management and how we communicate this reality to clients. Open conversations about the nature of risk and the uncertainty we face when making portfolio decisions can go a long way toward setting realistic expectations and helping clients understand that even after all we can do, the future is still uncertain. Our job is not to forecast exactly what will happen but to be there to help them deal with events as they come. K
Carl Richards believes that the world is a better place when people make smarter decisions about their money. That’s just one of the big ideas he promotes at BehaviorGap.com. Richards puts his ideas to work in the real world through his firm, Prasada Capital Management.

I spend a lot of time in the mountains in situations that might be considered risky. I realize that my activities involve risk and take the idea of managing those risks seriously. I do everything I can think of to mitigate the risk of being harmed, but when I look back at the risk to which I exposed myself, I realize that I am lucky to be alive. But here’s the tricky part: I didn’t know that at the time. Even though I did everything I could based on my knowledge and experience to “manage” risk, the biggest risk of all turned out to be what I didn’t know, events I never imagined. Even if you do everything right and follow all the rules designed to keep you safe, what often kills people in the mountains is the stuff they never see coming.
The Risk of War

In 1916, Frank Knight was a doctoral student at Cornell University working on his dissertation that was later published as Risk, Uncertainty and Profit. Knight made the now-famous distinction between risk and uncertainty. According to Knight, risk is randomness with knowable probabilities. Risk can be measured and presumably managed. Knight defined uncertainty as randomness with unknowable probabilities. Randomness is all the stuff left over after we think we have thought of everything. Because these unknowable risks can’t be measured, they certainly can’t be managed. Knight’s work forms the foundation for how we think about risk in our industry.
Managing Risk vs. Uncertainty

In February 2002, the country was dealing with the uncertainty surrounding the war in Afghanistan and what to do about Iraq. Donald Rumsfeld, the secretary of defense, was known for being decisive and confident (some would argue overconfident) even in the face of extreme uncertainty. On Feb. 12, 2002, Rumsfeld said: “There are known knowns.

Based on Knight’s work, we’re referring to managing randomness with known probabilities when we discuss risk management. In the sterile lab of modern finance, risk equals volatility. So, we assume that the range of outcomes is pretty much fixed within a normal distribution (bell curve). We assume we know, can measure, and, therefore, manage risk. In

16 Morningstar Advisor August/September 2010

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Morningstar Advisor - August/September 2010

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