RISK, UNCERTAINTY AND ACTS OF GOD
All investments involve some form of risk and require you to make a trade-off between the type and amount of risk you are willing to assume and the potential return you could receive. To realize a return on your investment, you must take some risk. Investment theory assumes that the higher the potential return, the greater the risk inherent in the investment. Unfortunately, while one might expect that risk can be avoided by refraining from investing, it doesn’t work that way. At the other end of the spectrum, we find that avoiding the financial markets and keeping their retirement savings under the mattress, investors do not eliminate risk; they expose themselves to a different set of risks. In fact, one of the riskiest things you can do is to not invest your money at all. This “non-decision” is, in fact, a decision. When you choose not to invest, you expose your money to purchasing power risk and eliminate the potential for growth of principal. The safest strategy for long-term investing is a well-diversified global portfolio that addresses your needs, goals and risk tolerance and that strikes an efficient balance between risk and return. However, building this portfolio is easier said than done. You must consider risk, uncertainty, and acts of God as you select your holdings.
Risk, in the statistical sense, refers to a known distribution of events and the chance that you may receive a lower return than you expected. For example, suppose you flip a fair coin ten times. It is quite plausible that you could have seven heads or tails when you expect five of each. If you flip the same coin 10,000 times your results will come much closer to fifty percent heads and fifty percent tails; flip 100,000 times and the results will be even closer to fifty percent heads and tails. This tendency to get closer to the expected result when you have a bigger sample is the law of large numbers. This law applies to many games of chance when you have independent (i.e. the result of the next coin flip does not depend on the previous coin flip) events.
Alas, while we are able to calculate historical distributions of many financial variables, it is not at all obvious that these distributions are stable enough to give us anything more than a rough estimate of risk. Thus when we talk of “financial risk”, it is not with the same precision as coin flipping and the law of large numbers. Nevertheless, by looking at the history of financial variables, we are able to quantify risk as it occurred in the past. Great care must be taken, however, not to predict the future based on the statistical history of such variables. It is best to treat the past data as only suggestive of the range of possibilities that might occur in the future.
The fact is, the future is unknowable. We refer to this unknowable future as immeasurable risk or “uncertainty.” Uncertainties, along with acts of God, are two of the most significant uncontrollable destroyers of wealth. Acts of God are frequently referred to in a financial crisis, but while acts of God often have devastating financial impacts, the term itself is actually a legal term that refers to events that are not the result of human action nor subject to their control. Tornadoes, hurricanes, and floods, for example, are acts of God. Fraud, war and divorce, being the result of human action, are uncertainties, rather than acts of God, even though they may have a profound effect on wealth. When compared with uncertainty, acts of God are different in one very important way; in the modern financial world, it is possible to purchase insurance to protect a portion of your assets against the damage resulting from these events.
When you, as an investor, have accumulated a surplus of cash, you have an investment dilemma and are exposing yourself to risk. Cash, not invested in some form of earning asset, assumes the risk that when you wish to spend that cash in the future it will purchase fewer goods than it does today. To benefit from saving money, you must mitigate this purchasing power risk. Indeed, saving money is the process of giving up the pleasure of spending today in anticipation of spending it in the future. If the money buys fewer goods at that future date when you are ready to spend it, you have delayed that pleasure for no purpose. However, the moment you purchase an earning asset with your surplus cash, you engage in a series of investment-related risks. The first risk you face is being defrauded. This risk can be greatly reduced by carefully following our Rules of the Road for Staying Rich.
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