It might seem silly to suggest that investors could learn from gamblers and tornado chasers but bear with me –people who laugh in the face of danger tend to know a thing or two about risk. In the financial world, risk assessment is a quantitative affair. Over the course of the past thirty years complex modelling systems have come to dictate trading strategies and risk protocols, but at what expense?
Quant models were criticised following 2008’s subprime debt implosion, blamed for failing to predict the ‘black swan’ event which subsequently trashed the financial system. The aftermath might have been very different had the financial world been a little less in thrall to machines. For in so doing, many disregarded the power of intuition.
As black swan events show, there is a need for human risk intelligence to scout out the potential monsters that machines can’t predict. If bankers were subjected to risk intelligence tests in the same way that doctors and pilots undertake regular competency exams, they probably wouldn’t come out with top marks, not if recent events are anything to go by argues Dylan Evans, author of Risk Intelligence: How to Live With Uncertainty.
Writing in The Sunday Times, Evans described how an innate grasp of risk and probability was a typical skill for the old school of traders who used to man the desks on Wall Street in the 1970s, before they were edged out by the quants. Most of these individuals were professional poker, bridge and backgammon players, relying on their wits and intuition, who knew that the only way to make big money was to do the opposite of what everyone else was doing, just as in tote betting on horse races.
The net result, said Evans, was that trading behaviour on Wall Street before the 1980s was highly uncorrelated. And while these non quants often stumbled into mini disasters, these always remained relatively local and the overall system kept ticking over. Paradoxically, it was only when the quants squeezed risk out of the system that the danger really crept in, because when something did at last go wrong, it went wrong everywhere at once, because their bets were all correlated.
In a recent article on the intensely interesting subject of asset liability management, the investment consultancy Towers Watson found lessons for investors in the actions of professional tornado chasers. Before setting out, a seasoned chaser will check meteorological forecasts to assess danger. This is equated to the first stage of asset liability management, essentially a quantitative form of risk management in which scenario forecasts are programmed to pick out which asset classes will meet return objectives with the fewest foreseeable problems.
However, statistics aside, chasers also anticipate that the worst will happen and therefore park their cars at crossroads to enable a rapid escape. Investors can take similar steps by diversifying exposures in their portfolios, the consultancy explained.
The precaution of always expecting the worst accepts that at the core of investing is uncertainty. It’s a fact embraced by the very best investors. This small band of individuals are characterised by their willingness to study behavioural patterns, do the opposite of popular market strategy, and crucially, learn from their mistakes, said Towers Watson.
The problem with the financial industry is that it is geared towards assuaging investors’ fears. Shortly after the crisis broke, journalist Ben Wright, now editor of Financial News, wrote: “Persuade a buyside client to trade twice as much and you can earn twice as much in commission; persuade a company to take over a rival and you generate advisory fees…Forecasts are no such thing, they are history lessons, and models are constructed on best guesses.”
And risk is also subjective. Jerome Booth, Head of Research at Ashmore Investment Management, commented last year that risk will vary for different investors in different places, depending on the nature of their liabilities. “There can never be a simple scale of risk. It is a reflection of different behavioural biases and liabilities,” he said.