{"id":8344,"date":"2018-12-18T00:01:57","date_gmt":"2018-12-18T05:01:57","guid":{"rendered":"http:\/\/www.jasonapollovoss.local\/?p=8344"},"modified":"2019-01-07T16:30:58","modified_gmt":"2019-01-07T21:30:58","slug":"real-risk-management-preferences","status":"publish","type":"post","link":"https:\/\/jasonapollovoss.com\/web\/2018\/12\/18\/real-risk-management-preferences\/","title":{"rendered":"Real Risk Management: Preferences"},"content":{"rendered":"\n

Several weeks back I described how critical is context in risk management<\/a>. I did this to bust out of the narrow confines of how financiers think about risk. As I pointed out risk in finance is most frequently thought of numerically and constrained by concepts of volatility, covariance, and value-at-risk (VAR). Having broken free of the quantity tether, I now want to briefly describe how preferences create risk.<\/p>\n\n\n\n

Preferences \u2192 Risk<\/em><\/strong><\/p>\n\n\n\n

Let me put it directly: <\/p>\n\n\n\n

Our preferences create risk.<\/em><\/p>\n\n\n\n

Examples should help to make this clear. Imagine the thousands of commuters heading home on a Friday afternoon, say in Bengaluru. They may be heading home via car, bus, train, bicycle, or on foot. It doesn\u2019t matter. What happens when a commuter, we will call her Commuter A, thinks to herself, \u201cI want to get home by 18:00 so that I can relax before going out tonight with friends?\u201d By stating her preference she has created risk for herself because there is a probabilistic chance that she does not get home by 18:00. And she has now taken on a whole set of probabilistic sources of risks to her preference. Her train may experience a track problem, or an outage. Or the station may be so full that she has to wait for multiple trains before boarding a train that gets her home in a timely manner. There could be a traffic accident that clogs her roadway. And so on. Her preference to be home by 18:00 immediately sets her in relation to a whole set of probabilistic outcomes that did not exist before her preference.<\/p>\n\n\n\n

Now let\u2019s imagine another commuter, we will call her\nCommuter B. If her preference is very different from that of Commuter A, say\nshe wants to see fashionably dressed people on her commute home and her arrival\ntime home does not even enter her mind. What is her risk that she does not\narrive home by 18:00? Zero. Why? Because this is not a context that she cares\nabout, she has no preference about her arrival time home, so it is not a risk\nto her. By contrast, Commuter B does experience a probability that she does not\nsee fashionably dressed people. This is her risk, and it was created by her\npreference. Whereas, Commuter A does not experience this risk at all. In fact,\nit is entirely possible that if Commuter B lengthens the time of her commute\nthat she actually reduces her risk of not seeing fashionistas.<\/p>\n\n\n\n

Granted, these may not seem like very serious risks, but the\nconcept scales and transcends. In investing what is the risk of\nunderperformance? It is a stated preference for a performance outcome that is\nnot met by an asset\u2019s returns. In fact, if two different investors have two\ndifferent required rates of return that discount the identical stream of cash\nflows then the risks faced by both of them are entirely different, despite the\nunderlying reality being identical. If an investor literally has no performance\npreference as to an outcome, what is the investor\u2019s real risk of\nunderperformance? It is certainly the case that other investors may observe the\noutcome of the investor with no performance preference and themselves label it\nrisk, but from the perspective of the individual directly affected, if they\nhave no preference about the outcome then how can we say there is risk for them?<\/p>\n\n\n\n

Likewise, when a company releases a new product and its\nsales do not meet sales expectations\/ preferences many investors believe it is\nnatural to identify and discuss many kinds of risks. These can include things\nlike: revenue risk, profit risk, marketing risk, business model risk,\ncompetitive risk, and so on. Importantly, the company\u2019s risk is different than\nthat faced by investors. And within the investor set, they each experience the\nrisks differently because of their preferences. After all, a short seller has a\npreference for failure and may view underperformance favorably. So, again, the\nrisk here is created by preferences and expectations on the part of the\nobserver. <\/p>\n\n\n\n

Even in the real world where many consider premature death\nfrom disease, accidents, war, famine, and so on to be risks, what if no one has\na preference as to the outcome? It may be hard to imagine a world where preferences\nare the source of risk because so much of the Western mindset is about\nformulating opinions, and from a very young age. \u201cJane, do you want a cherry or\na strawberry candy?\u201d \u201cJames, do you like the cartoon?\u201d But this very act of\nidentifying preferences and judgments about nearly everything and every moment\nis the source of risk. If you emphatically, authentically do not care about the\noutcome of something, even your physical well-being, what is the risk to you?<\/p>\n\n\n\n

I am arguing that risk is subjective, but others will\ncertainly argue that it is possible to identify risks objectively. For example,\nthe risk of suffering an early demise. This subjectivity vs. objectivity bit is\nsomething I will address in the next article in this series. Another thing\nlurking in the background that I promise to address is the tension between\ntemporal issues, such as probabilities are established by observing past\nactions and how these are used to evaluate future outcomes, and how this divide\nwhen coupled with preferences is what we refer to as risk.<\/p>\n\n\n\n

Logically your next question has to be: Why the hell does\nthis point matter to me as an investor?<\/p>\n\n\n\n

\n\n\n\n

 Jason A.\nVoss, CFA – Your Next Excellent Hire<\/a><\/p>\n\n\n\n

I would love it if you would receive notification of my new articles \u2013 sign up here<\/a><\/strong> \ud83d\ude42 Don\u2019t forget to comment on the article in the space below. Thanks!<\/p>\n\n\n\n

\n\n\n\n

Be Careful What You Prefer For<\/em><\/strong><\/p>\n\n\n\n

If you agree that your preferences are what create your risk\nthen it naturally means that you must:<\/p>\n\n\n\n

Be\ncareful what you prefer for!<\/em><\/p>\n\n\n\n

All too often our preferences are on autopilot and we do not\nthink about how they came about and were given credence and energy. Why do we prefer\nto be exclusively growth\/value\/GARP\/small-\/mid-\/large-cap investment managers?\nWhy do we prefer to calculate a required rate of return based on the Capital\nAsset Pricing Model? Why do I need consultants to grow my assets under\nmanagement? Why do I issue financial statements to my customer that they cannot\nunderstand? Why do I only invest in my domestic market? Each of these\npreferences lead to our interpretation of our outcomes, as well as those of\nevery person to whom we communicate these preferences. Choose a benchmark and\nsay your preference is to beat it and you now have taken on all kinds of risks,\nespecially if you communicate these preferences to others and contractually\nagree to deliver them.<\/p>\n\n\n\n

The preceding paragraph features preferences that are\nexistential ones for most investors, but what about a more mundane concern? It\nis our preferences that are also the source of our behavioral biases. If I\nprefer a stock to which I have given a 5% allocation in my portfolio perform\nexceptionally well, then I also likely increase my susceptibility to\nconfirmation bias. After all, if the performance vs. expectation gap (i.e risk)\nis large it means I need to find a reason to keep on believing that the gap\nbetween performance and expectation will narrow. People and ideas that support\nmy belief become very appealing because they confirm my preference to continue\nto own the stock is warranted.<\/p>\n\n\n\n

Further, if I purchase a security and have a performance\nexpectation then I also then put myopic loss aversion in my contexts, too.\nAfter all, it is the preference for outcome that leads to a feeling of loss. I\ncould go on, but spend some time also thinking about how your preferences\nimmediately put you in danger of overconfidence bias, mental-accounting bias,\nanchoring bias, and so on.<\/p>\n\n\n\n

To avoid these errors requires that as investors we develop\nas a first line of defense an explicit consideration of our preferences. We\nshould eliminate all unnecessary preferences. If our preferences are made explicit\nthrough contemplation then they can be avoided altogether, or managed if they\nare necessary preferences\/risks. If they are implicit though, then our chance\nof loss becomes even higher. Does this make sense? <\/p>\n\n\n\n

Preferences Can Lead to Other Unwanted Preferences<\/em><\/strong><\/p>\n\n\n\n

Examining our preference as investors is also important\nbecause if they are unexamined they frequently lead to other preferences\nbecoming rooted, and these may lead to ridiculous choices on our part. Going\nback to the example above with Commuter A who wants to be home in Bengaluru on\na Friday night by 18:00. If she is driving an automobile and she begins to look\nat the clock and realizes that the probability of her realizing her preference\nis diminishing \u2013 due perhaps to Friday evening traffic being more congested\nthan normal, or an accident \u2013 if she does not examine her preference it may be\nthat she starts engaging in low probability of success activities that risk her\nphysical safety. She may switch lanes more frequently and into gaps that are\nmore narrow in an attempt to \u2018get ahead\u2019 in the line of traffic. In so doing,\nher initial preference, entirely subjectively determined, leads to other\npreferences and behaviors and ones with possible detrimental consequences, like\na wreck, a police citation with its associated fines, and physical harm to\nothers. Because she started with a subjectively determined preference to be\nhome at 18:00 \u2013 an entirely arbitrary choice \u2013 she actually puts herself at\ngreater risks. Ouch!<\/p>\n\n\n\n

An example of this same kind of problem is \u2018doubling down\u2019\non a position when it declines in value due to a negative report. If we do not\nexamine our original preference and the assumptions that led to it, then we may\nend up taking on additional, more consequential risks. Ouch!<\/p>\n\n\n\n

In my next article I will discuss the subjectivity vs.objectivity spectrum with regard to risk.<\/p>\n\n\n\n

\n\n\n\n

 Jason A.\nVoss, CFA – Your Next Excellent Hire<\/a><\/p>\n\n\n\n

I would love it if you would receive notification of my new articles \u2013 sign up here<\/a><\/strong> \ud83d\ude42 Don\u2019t forget to comment on the article in the space below. Thanks!<\/p>\n\n\n\n

\n\n\n\n

Part three examines the difference between subjectivity and objectivity<\/a> in real risk management.<\/p>\n","protected":false},"excerpt":{"rendered":"

Several weeks back I described how critical is context in risk management. I did this to bust out of the narrow confines of how financiers think about risk. As I pointed out risk in finance is most frequently thought of numerically and constrained by concepts of volatility, covariance, and value-at-risk (VAR). Having broken free of […]<\/p>\n","protected":false},"author":2,"featured_media":8345,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_et_pb_use_builder":"","_et_pb_old_content":"","_et_gb_content_width":"","footnotes":""},"categories":[3],"tags":[],"class_list":["post-8344","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-the-blog"],"_links":{"self":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/posts\/8344","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/comments?post=8344"}],"version-history":[{"count":0,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/posts\/8344\/revisions"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/media\/8345"}],"wp:attachment":[{"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/media?parent=8344"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/categories?post=8344"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/jasonapollovoss.com\/web\/wp-json\/wp\/v2\/tags?post=8344"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}