On Monday past, I asked if diversification mattered. Predictably I heard about the admonition to not keep all your eggs in one basket. The all eggs in one basket idea shows that people do not understand risk.
I don’t know anyone who keeps eggs in baskets any more. The modern version is don’t put all your backups on the same hard drive. The reasoning is the same. Without spreading the physical risk around, if you lose one, you lose them all. So for safety, people give up simplicity.
For those of you who don’t think backup is important, computer professionals believe that you do not care about any file that does not have at least three independent backups. Notice the independent idea.
Independent location reduces only one kind of risk. Catastrophic risk.
There are two forms.
Investment risk is variability. It cancels itself out over time. Crushed eggs don’t recover, but stock prices do. With investments, the only risk an investor has is that they might need their money back at an inopportune time. That possibility has nothing whatever to do with the investment characteristics of their securities. It has to do with their absent plan or the vagaries of the world. Those have more similarity with the second kind of risk.
Catastrophic risk is adverse and unpredictable in time. Like dying or having you house burn down. People make the intuitive mistake of confusing market volatility with catastrophic loss and they are the worse for it. There is a price to diversify, just as there is a price for offline backup and extra baskets.
November 3rd, 2016 Mark Zuckerberg lost $3 billion of market value on his Facebook stock holding. I doubt he noticed. You should know how much you could tolerate and what you would do should it appear.
Permanent losses matter more.
Market volatility losses are not risk except at a moment in time. Without a transaction there is no real loss. Variations do however, induce a sense of loss in the investor’s mind. The feeling is there, but it is not complete. Give it some time and it will adjust.
You manage the feeling or risk in two ways.
- Rationally understand how markets price securities. The price reflects the feelings of everyone interested in that security. It is an average of the emotional content of the players and is only somewhat connected to the actual business value. Microsoft is the same company at $60 per share as it is at $50. Focusing on business value makes sense and failure to deal with that well will result in real losses. People make transactions when they are fearful.
- Don’t look at the market price so often. Risk exposure is a factor. Because people make mistakes when afraid, reducing their exposure reduces their probability of error.
You manage real catastrophic risk differently.
- Reduce exposure is a good beginning. Don’t drive drunk. Don’t store gasoline in closed spaces. Exercise and eat well.
- Once you reduce your exposure as far as possible, insure the value of the loss that remains. That does not chance the probability of loss, but it changes how the loss affects you emotionally and in the end that is the purpose of diversity.
Be sure to know what risk means to you. Risk is relative. Losing $1,000,000 is not always ten times worse than losing $100,000. Losses from market volatility should be seen as contextual.
Advisors and journalists should spend time on what risk means to their clients and readers. The traditional “Know Your Client” risk assessment tells people little of value. It usually shows that people are highly risk tolerant and that stays true until they have a market value loss. Then they are highly risk averse.
It is not easy.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772