“When models turn on, brains turn off.”
I have been thinking a great deal about risk over the past couple of years. The depth of the financial crisis took many of us by surprise. I made mistakes. I am sure you made mistakes. In fact, the whole industry made mistakes, from which we should all learn. Whether we will is another story, but we should try. Making those mistakes is all the more frustrating because I was aware of the dangers but, like most others, underestimated the magnitude. In fact I wrote about them – see for example the October 2007 Absolute Return Letter (Wagging the Fat Tail).
Now, let’s distinguish between trivial risk (say, the risk of the stock market going down 5% tomorrow) and real risk - the sort of risk that can wipe you out. The geeks call it tail risk, and James Montier provided an excellent definition of it in his recent paper, The Seven Immutable Laws of Investing, where he had the following to say:
“Risk is the permanent loss of capital, never a number. In essence, and regrettably, the obsession with the quantification of risk (beta, standard deviation, VaR) has replaced a more fundamental, intuitive, and important approach to the subject. Risk clearly isn’t a number. It is a multifaceted concept, and it is foolhardy to try to reduce it to a single figure.”
Following James’ line of thinking, let me provide a timely example of the complex nature of tail risk:
The Japanese disaster
Contrary to common belief, the disaster at the Fukushima Daiichi nuclear power plant was not a direct result of the 9.0 earthquake which hit Northeastern Japan on 11 March. In fact, all 16 reactors in the earthquake zone, including the six at the Fukushima plant, shut down within two minutes of the quake, as they were designed to do. But Fukushima is a relatively old nuclear facility – also known as second generation - which requires continuous power supply to provide cooling (the newer third generation reactors are designed with a self-cooling system which doesn’t require uninterrupted power).
When the quake devastated the area around Fukushima, and the primary power supply was cut off, the diesel generators took over as planned, and the cooling continued. But then came the tsunami. Around the Fukushima plant was a protection wall designed to withstand a 5.2…
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