Risk and the Smart Investor

I recently enjoyed an exchange with Jeff Grimshaw, co-author of Leadership Without Excuses, and a partner at MGStrategy. In Risk and the Smart Investor I filled more than a few pages writing about the importance of establishing a ‘culture’ of risk management. If implemented successfully, that culture will extend from the boardroom to the ground floor. And the understanding that mistakes are really just opportunities for learning should be one of its central tenets.

Jeff: You’ve written about the importance of creating a culture that sees errors as opportunities for learning. There’s a chapter on this in Leadership without Excuses. For example, we tell the story of Walt Buckley, CEO of the Internet Capital Group, who leads with the philosophy that “mistakes are intellectual capital.” But he’s the exception rather than the rule. What are some other practices or traits that you’ve found in organizations that see errors as opportunities for learning? How do you build this in to the way organizations think about and manage risks?

David: I started Risk and the Smart Investor with a quote from W. Edward Deming, who said: “It is not necessary to change. Survival is not mandatory.” I went on to say that the darkness of uncertainty can actually create the light of understanding, in the sense that learning to find your way in the dark can lead to new ways of thinking, force you to learn from your mistakes, and make you stronger and more resilient. Organizations then see errors as opportunities for learning, are open to change, and spend a lot of time on post mortems to ensure that the error never occurs again—anywhere in the organization.

Jeff: Well said…and I agree completely.

I don’t blog every day. I write blog posts only when something catches my eye and makes me think.

Henry Lichstein, a valued friend and colleague from the old days at Citibank recently sent me an article written by Nouriel Roubini, professor of economics at the Stern School of Business at NYU. The article—“U.S. Fiscal Policy: A Train Wreck Down the Line?”—isn’t for the faint of heart, but it underlines the need for sound risk management in these volatile economic times.

“What has been the fiscal performance of the Obama administration and what is the outlook for U.S. fiscal policy after the midterm elections? The Obama administration inherited the worst economic and financial crisis since the Great Depression and a budget deficit that was–after unsustainable tax cuts in 2001-2003, a severe economic crisis and the TARP bailout–already close to a trillion dollars. There is now plenty of empirical evidence—including studies by the non-partisan Congressional Budget Office (CBO)—that the $800 billion fiscal stimulus implemented in 2009 (even if not ideally designed), together with zero policy rates, large scale QE and a massive backstopping and ring-fencing of the financial system, prevented this Great Recession from turning into another depression. In effect, the U.S., as well as other advanced economies and emerging markets, learned the lessons of the Great Depression and of Japan’s experience in the 1990s. Facing collapsing private demand, the U.S. (and many other countries) implemented a fiscal and monetary stimulus and a quasi-fiscal backstop of the financial system that led to the, however anemic and weak, recovery of the U.S. and global economy.”

But Roubini’s not done there, and concludes with the following.

“To shock the political system into the necessary fiscal discipline, one would rather need a spike in long rates caused by bond vigilantes eventually waking up and forcing the political system to make tough choices rather than kicking the can down the road. A bond market shock is thus necessary to break this political gridlock.

In conclusion, the Obama administration did the right thing early on to avoid Hoover-style fiscal policies that would have sunk us into another depression and is right now in pointing out the risks of early fiscal austerity. But the Republican Party clings with religious fervor to its belief in voodoo economics (the economic equivalent of “creationism”), i.e., in reckless and unsustainable tax cuts. The Obama administration and most Democrats, meanwhile, so far appear unwilling to tackle the issue of long-term entitlement spending. Fed monetization may forestall the wreck, but the political course is clearly heading for trouble. Right now, the light at the end of the tunnel is a fiscal train wreck.”

In Risk and the Smart Investor I wrote about the importance of creating a culture that sees errors as opportunities for learning. As a result, this article—Do No Harm, by Claudia Kalb for Newsweek magazine—really struck a familiar chord. I’d like to think that it’s further evidence that the medical profession, in addition to banks and investment firms, is continuing to implement sound risk management practices to reduce medical mistakes. Ms. Kalb, in the September 27, 2010 edition of Newsweek, writes:

“Undoing a culture is hard, especially one steeped in hierarchy and intimidation, where doctors tend to reign supreme and nurses, pharmacists, and technicians fall into the ranks below. “What underlies it is arrogance,” says Pronovost, an anesthesiologist and director of Hopkins’s Quality and Safety Research Group. In his book he describes a run-in with a surgeon who refused to switch from latex to non-latex gloves during a hernia operation, despite Pronovost’s concern that the patient was having a potentially fatal latex-allergy reaction. It was only after a nurse picked up the phone to call the hospital president that the surgeon relented. “This patient,” Pronovost writes, “could have died from ignorance and arrogance—a lethal combination.”

I wrote Risk and the Smart Investor because I wanted to share what I’d learned about risk management and decision-making during my long and successful career in the financial world. Once the book was published, though, and I began to receive comments from friends, colleagues, and even total strangers who had read it, I was surprised at how some readers put the book to use in ways that not even I had imagined. Jeffrey Towson, for instance, of the Global Gold Rush Report, reviewed Risk and the Smart Investor (see review) and afterward made the following suggestion.

“While reading this, I promptly flagged several of the checklists and loaded them into my Blackberry and screensavers.  The hope is that I will get into a more regular habit of checking this against my investments and operations.   This is one of those books you should integrate into your daily habits.”

I couldn’t have put it better myself.

During our recent interview Jacob Wolinsky of gurufocus.com asked me the following question.

Q: What are your thoughts on VaR and the role it played in the financial crisis?

My answer (below) reflects my belief that effective risk management is based on sound principles, not crunching numbers.

A: VaR is the amount of money a specific investment can lose in a single day. Traditionally used to measure the value at risk on discrete transactions, it has now begun to be applied across entire portfolios. Its strength is that it is easily calculated. It’s weakness, if it has one, is that it is based on historical loss data, which do not necessarily reflect current conditions. For that reason it can provide you—and regulators, I might add—with a false sense of security. VaR is also a poor indicator during extreme events—it tells you the best likely outcome, not the worst.

In Chapter Three of Risk and the Smart Investor I discuss one of the most important aspects of risk management—determining your appetite for risk. This is not as easy as it seems. Most individual investors simply want to maintain their present standard of living—that is, they are risk averse—while institutional investors usually have to deliver a return that exceeds a certain benchmark, plus costs. Nonetheless, there are limits to the risks the latter will take to deliver those returns. For a somewhat unusual, if common sense example, go to Jim Lynch’s Actuarial Opinions and find the excerpt on risk management–Quotable, Risk management edition–he pulled from Risk and the Smart Investor.

The following excerpts are from David Merkel’s The Aleph Blog. I’ve enjoyed several lengthy conversations with David, as well as a Q and A exchange (Twenty Answers from the Author of Risk and the Smart Investor) you can find on his excellent blog.

I had the pleasure today of interviewing David Martin who wrote the book “Risk and the Smart Investor.” Unlike most of my book reviews, I had the fun of doing a voice interview and doing a written Q&A as well.  This piece will go over my voice interview.

Before I start, why did I decide to do so much with this book?  I did this because I have a love of risk management.  As I read through his book, I sensed a kindred soul who really got what is behind risk management.  I will not put out this much effort for an ordinary book.  I really liked this book, and after my voice interview I can say that I really liked David Martin.

My first question to David Martin was to ask you what motivated him to write the book.  He replied to me that as he had gone through life and learned things, his satchel filled up more and more. The book was a way of emptying his satchel and giving back to average people.

If I might interject, that is my reason for writing this blog.  I’m not in it for the money; I don’t think David Martin is either.  But for some of us, when you have learned a lot, you feel a need to share it with others, not so much for your ego, but that others can benefit.

Not every book grabs me at first.  “Risk and the Smart Investor” was one such book.  But it grew on me.  Having been through many exercises in risk control inside insurance companies, I can sympathize with the much more complex job that it is to control risk inside investment banks.

Leo Tilman, President of L.M. Tilman & Co. and a faculty member at Columbia, sent me the following video, and if you have a half an hour to devote to a lecture on the cyclical nature of financial history try Niall Ferguson’s Empires on the Edge of Chaos. (Begin at 3. Historical Cycles of Empire Decline, to avoid the opening remarks.) While entertaining, Ferguson’s notion that the US is in decline—in fact, Ferguson says the U.S. economy is ready to collapse—is still old news. In other words, we’ve heard it before, and yet we’re still here.

If Ferguson were right the U.S. economy would have been “lights out” after Lehman’s collapse. Yes, in Risk and the Smart Investor I wrote that the inevitable takes a long time to happen, but when it does it happens quickly. At yet at the beginning of the final section of my book—Reevaluation—I also suggest that my readers focus on more likely scenarios, not Armageddon. From page 211:

“Whenever I consider [Herman Kahn’s] work, I can’t help but think back to the time we were asked if our bank vault would float in the event a tidal wave hit New York City—as if a bank vault, whether or not it would float down the Hudson River, would be of any interest to the survivors of such an event.”

In the past four months private investors have pulled more than $50 billion out of U.S. stock funds, continuing a trend that began last spring and shows no sign of abating (see Tom Lauricella’s recent article in the Wall Street Journal: Where’s the Appetite for Risk?). Worried first by the banking crisis in the Euro Zone, and then by economic data that show the U.S. recovery losing steam, private investors are pulling their money out of anything with even the smallest risk.

The Wall Street Journal’s Jason Zweig, in a column written earlier this summer, asks the reasonable question: why do investors buy when the market’s rising, and sell when it’s falling? (See Hazardous Waters: Should Investors Bet on Rising Risk?)

I treat this topic at length in Risk and the Smart Investor—i.e., risk is not something to be avoided, but something to be embraced, as long as it’s only one part of a balanced, long term investment strategy.

After having incurred significant losses of principal over the past few years many investors are now asking themselves whether the sales pitches behind the products they bought were too good to be true, and whether the expected returns justified the risks. Some losses, of course, were unavoidable, but others resulted from investors putting their trust in something, or someone, who didn’t deserve it. Put another way, some investors may have purchased the sizzle and not the steak. So the question now becomes, can you tell when someone is shading the truth, or even lying to you? The answer, of course, is yes, and for the doubters among you I’ll begin by pointing to the almost supernatural ability of some wives to detect even the smallest half-truth on the part of their husbands. What gives them away? The husbands will probably never know, but investors could learn a thing or two from the process.

To start with you should always begin by asking yourself whether what you’re being told sounds true, or sounds too good to be true. Sure, pessimists are everywhere, but no one ever lies about things being worse than they really are. Lies, in fact, are useful only when listeners have to be assured that things are better, or safer, than they really are. So after you’ve asked yourself whether something is too good to be true, ask yourself if you can believe the underlying assumptions of the story you’re being told?

In addition to pictures of the future that are far too rosy, it turns out that there are a number of ‘tells’ you can use to identify half truths, or even outright lies, and a number of them appear in David Larcker and Anastasia Zakolyukina’s article, How to Tell When the Boss is Lying.

To start, the authors advise you to listen carefully when someone starts speaking in generalities, or using superlatives to describe every situation. And pay attention when anyone not wearing a crown speaks of themselves in the third person, or curses frequently. I’ll leave the rest to those of you who are interested enough to click on the link, but the truth is that there are ways to spot a lie.