Introduction: The Problem and Solution of Risk

What is the riskiest thing you can do with your money? Many people would say gambling it away at a casino.

But, what is the riskiest thing a casino can do? Not having safeguards against cheating, of course.

If a cheater goes on a big enough "winning" spree, he could bankrupt a casino. Casino's are very aware of this risk, and take extreme measures to prevent cheating - after all, the survival of their business relies on it.

They pull out all the stops to prevent cheaters and pour resources into intricate surveillance systems that can detect even the most adept slight of hand.

But you might be surprised to learn that despite the risk that cheating poses to casinos, casinos' biggest losses oftentimes aren't related to cheating at all.

At one casino, the four largest losses resulted from:

1. A star performer being maimed by a tiger,

2. A contractor injured during the building’s construction,

3. A tax violation caused by an employee failing to send proper documentation to the IRS, and

4. One of the owners stealing from the casino to pay ransom for his kidnapped daughter.

The real risks weren’t the ones covered by security measures. Instead, they were unpredictable events no one had foreseen.

Nassim Taleb recounts the above anecdote in his book "The Black Swan" in order to demonstrate that risk is often impossible to predict in advance, despite advanced statistical models created by "experts."

He refers to these types of risks—unforeseen events that no one predicted but which occur nonetheless—as "Black Swans."

Hindsight is 20/20, but if you turn the pages of a history book you will see that it is filled with Black Swans. The terrorist attacks of 9/11, rise of the internet, and the 2008 subprime mortgage crises, as examples.

It was this realization that forms the crux of Taleb's thesis – extreme events that no one predicts are far more likely to happen than statistical models represent.

Let that sink in.

Despite what the "experts" tell you, no one actually knows what the future holds. If you're anything like us, this realization will shift the way you think about your decisions and plans for the future, especially as it pertains to your investments.

After all, if we don't know what the future holds is there even such a thing as investing? Isn't it all just speculation at that point? How can we make any decisions about how to allocate our capital?

The good news about Black Swans is that even though we can't predict them, they aren't always bad. After all, lot's of people profited beyond their wildest dreams from the dot com boom, while others profited by shorting dot com stocks when the bubble burst.

In essence, risk itself is an agnostic force that can be both beneficial and detrimental to individual investors based on how they are positioned.

The game is understanding risk, and especially Black Swans, and understanding market dynamics well enough to position yourself to maximize your benefit from risk, while simultaneously minimizing the downside of risk.

Everyone is aware of the dangers of inflation, and even hyper inflation, nowadays, but what about deflation?

It seems far fetched, but so does everything until it happens. Everyone is positioned to take advantage of the upside volatility of stocks, but what are they doing to protect their downside, and even gain from stock market crashes?

How do you set yourself up to not only be protected against the downside risk posed by Black Swans, but also take advantage of their upside?

That is the subject of this series on the Libertas Dual-Portfolio Risk Management Framework.

To paraphrase William Bernstein, there is no such thing as Black Swans, only people who haven't studied history.

All of the losses Nassim Taleb outlined in his casino example could have been protected against if the casino owners had just thought more broadly about history and the realm of the possible.

These were not the first examples in history of theft or liability leading to losses, after all.

Note that this is very different than trying to "predict the future."

Saying that "at some point in the future, theft could cause losses for us, so we should prepare for that type of risk" is quite different from saying "on November 13, 2027, a group of organized criminals will steal $2.3 million from the casino."

By studying what the quantitative metrics don't show us, we have gleaned a sense of the types of risk that exist for individual investors and how to mitigate against them - even using them to our advantage.

That certainly doesn't mean that we can predict the future, just that we know what types of things have happened in the past and will likely come to pass again, and how to construct a portfolio framework to best position ourselves regardless of the future.

But before we go into the details of this portfolio framework, you need to understand that there are 7 major categories of risk that pertain to individual investors:

1. Psychological Risk

2. Asset Risk

3. Economic Risk

4. Timing Risk

5. Tax Risk

6. Institutional Risk

7. Jurisdictional Risk

As you understand each type of risk, you will begin to appreciate the opportunities to minimize downside and maximize upside potential in each.

The first type of risk is psychological risk.

This is the most important kind of risk because an uncultivated mind is the biggest risk to everyone, whether they are an investor or not.

Let’s dig in…

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