TAIL RISK
By Karl Arnold Belser
31 March 2015



I heard a talk that was given at Google by Howard Marks titled The Most Important Thing , which,in short, is: Avoid any probability density function   tail Risk when such a tail event might produce a disastrous outcome. For example, sky divers have a 99% probability of a successful dive, but the 1% tail risk is that you die. The message here is to avoid any activity or investment that can ruin you.

I wrote my Investing Rules,in 2011, and the closest I came to this idea was: "Determine How much Money You Need - Don't Bee Greedy". My message was that one should have moderate expectations so that one is not tempted to take on too much risk. Marks' corresponding message is to aim for consistent, realistic gains, even though they might not be outstanding and never take a risk that could wipe you out.

Marks is a value investor. He points out that one can never be more than average if one invests like everyone else does. See my post Luck and the Paradox of Skill.
Hence Exchange-Traded Funds (ETF) covering a whole market segment will guarantee only average results. Since the averages have been pretty good, this is probably an acceptable way to invest for many people. However, I note that all shares, even the most risky, might be included in the ETFs.

In order to consistently make above average returns one must find shares that are under priced by the market. Unfortunately one generally does not know if the market pricing is correct. Robert Schiller has shown that on-the-average shares with a low price to earnings (PE) ratio do statistically better than the total market averages. This suggests that a low PE ratio contains some information about future prospects of a company. The other type of information is negative mob behavior due to some aspect of the company's business. The share price may undershoot in price and become a value play.

There may be other ways to assess a company's value, but I don't know how to make this assessment. I'm pretty sure that Warren Buffett of Berkshire Hathaway does, however, based on his track record.

Enough about investing. Tail risk occurs elsewhere in some important areas that people might want to consider when managing their lives.

1. Marriage

Marriage is a prisoners dilemma type of zero sum game that is only played once. Hence, one of the two married people can double cross (divorce) the other and get rewards of half of the estate value and possible monetary support from the other. The solution is pretty simple: don't get married.

I have seen statistics that suggest that about half of the couples that live together are not married. One might suspect that people are evolving to recognize this tail risk. Even a prenuptial agreement may not protect both parties.

2. Doctors and financial advisers

Doctors make mistakes and one should probably investigate any illness or drug usage personally. Remember doctors generally do not understand the seriousness of false positives. See my post False Positive Probabilities.

The situation with financial advisers is that they likely have a conflict of interest. The best solution is personal study and involvement in your investments.

3. Taking on debt

The use of debt, or leverage, in investing and in supporting one's life style is risky. If the value of the assets you borrow money to buy goes down or you loose your job you may be ruined.

Similarly taking on student loans without a clear idea about how the money will be repaid  will in many cases make the student loan debtor a debt slave for life. See my post The Student Loan Dilemma.

4. Police, fire and combat troops

There is clear danger in these professions. The police and fire professionals are at least paid for the risk that they take. Soldiers are not. The tail risk is death or serious debilitating injury that will never be compensated for by the government.

5. Extreme Sports

I mentioned the sky diving tail risk above, but there are many more examples. US football is currently recognizing the serious risks of head injuries. Boxing, scuba diving and hang gliding are other examples.

6.  Visiting dangerous areas of the world

It is clear that it would be foolish to visit Syria today, but it would be equally risky to visit many parts of Mexico or even inner city ghettos in the United States.

7. Not using protective devices

Using seat belts while driving, goggles, gloves, and protective shoes when in machine shop areas are examples.

8. Poor driving habits

Running red lights and driving too closely to the car in front are just accidents waiting to happen.

---

Clearly one has to decide what level of risk is acceptable. Flying in an airplane and driving a car have risks, but the risks are small enough that the risk is probably worth it. One must know how much risk is acceptable.

People often err in setting the risk limit threshold too high. The point is that is one might want to become conscious that risk can be managed.
   
Last updated April 1, 2015
KARL BELSER HOME PAGE
HTML 4.01