...cost of risk mitigation is often worse than the feared outcome...
From public policy to private investing, it is the central question of our time: how high a price should we pay to keep ourselves safe from harm?
And this begs even more fundamental questions: should risk mitigation come at a cost at all, or should it rather come with rewards? That is, shouldn’t risk mitigation be “cost-effective”? And if not, what is it good for?
Think of your life like an archer releasing just one single arrow at a target. Naturally, you want to make your one shot at life a good one — to hit your bullseye — and this is why you mitigate your risks: to improve your precision (or the tightness of the grouping of your potential arrows) as well as your accuracy (or the closeness of that potential grouping to your bullseye). We often lose sight of this: safety is instead perceived as improving precision (removing our bad potential arrows) at the expense of accuracy.
The fact is, safety from risk can be exceedingly costly. As a cure, it is often worse than the disease. And what’s worse, the costs are often hidden; they are errors of omission (the great shots that could have been), even as they mitigate errors of commission (the bad shots). The latter are the errors we easily notice; ignoring the former for the latter is a costly fallacy.
Of course, we expect politicians to commit this risk mitigation irony. Ours is the great age of government interventionism — from corporate bailouts to extraordinary levels of debt-fuelled fiscal spending and central bank market manipulations. Fallaciously ignoring errors of omission to avoid errors of commission essentially is the job of politics, as every government programme involves hidden opportunity costs, with winners and losers on each side.
More surprising, even investors engage in risk mitigation irony as well. They strive to do something — anything — to mitigate risk, even if it impairs their portfolios and defeats the purpose. The vast majority of presumed risk mitigation strategies leave errors of omission in their wake (ie underperformance), all in the name of avoiding losses from falling markets.
Modern finance’s dogma of diversification is built around this very idea. Consider diversifying “haven” investments such as bonds or, God forbid, hedge funds. Over time, they exact a net cost on portfolios’ real wealth by lowering compound growth rates in the name of lower risk. They have thus done more harm than good.
The problem is, such safe havens simply do not provide very much (if any) portfolio protection when it matters; therefore, the only way for them to ever provide meaningful protection is by representing a very large allocation within a portfolio. This very large allocation will naturally create a cost burden, or drag, when times are good — or most of the time — and ultimately on average. Over time, your wealth would have been safer with no haven at all.
An overallocation to bonds and other risk mitigation strategies is the principal reason why public pensions remain underfunded today — an average funding ratio in the US of around 75 per cent — despite the greatest stock market bull run in history.
For instance, a simple 60/40 stocks/bonds portfolio underperformed the S&P 500 alone by over 250 per cent cumulatively over the past 25 years. What was the point of those bonds again? Cassandras typically and ironically lose more in their safety interventions than they would have lost to that which they seek safety from.
Most investor interventionism against looming market crashes ultimately lead to lower compound returns than those crashes would have cost them. Markets have scared us far more than they have harmed us.
While Cassandras may make great career politicians and market commentators, they have proven very costly in public policy and in investing. We know that times are fraught with uncertainty, and the financial markets have perhaps never been more vulnerable to a crash. But should we seek safety such that we are worse off regardless of what happens?
We should aim our arrows such that we mitigate our bad potential shots and, as a direct result, raise our chance of hitting our bullseye. Our risk mitigation must be cost-effective. This is far easier said than done. But by the simple act of recognising the problem of the deceptive, long-term costs of risk mitigation, we can make headway. If history is any guide, this might just be the most valuable and profitable thing that any investor can focus on.
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Mark Spitznagel is the founder of Universa Investments and author of Safe Haven: Investing for Financial Storms. Universa invests in options that hedge against market crashes.