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Risk Management in the Age of Uncertainty
In the 1600s, merchant ships faced enormous uncertainty while delivering cargo throughout the world. Rough weather, pirates, foreign gunships and disease consistently threatened their voyages, and the timing, severity and probability of these risks were unknown. Prior to the use of sophisticated weather and navigation instruments and advancements in ship design, shipowners, trade financiers, maritime insurance companies and crews took on great risk during each journey.
We are currently in the most uncertain economic environment in a generation, and many of our forecasting and risk management tools have been rendered useless. The range of policy and economic outcomes in the pre-pandemic world were more limited and well defined. We now are tasked with navigating through an environment with little certainty and increased risk. As we learn more about the novel coronavirus and move closer toward a vaccine, we have gained clarity about some future risks but remain blind to others. COVID-19 has presented great challenges and forced businesses to rethink their long- and short-term corporate strategy as well as their capital structure. As a wealth manager, we have had to adapt our business to a more virtual world and manage portfolios through a different risk management lens.
Risk vs. uncertainty
Emotionally, humans do not deal well with uncertainty. It makes us uncomfortable. The scientific term for this is “ambiguity aversion.” Essentially, we prefer to know the probability of potential outcomes — which is commonly defined as “risk” — and we loathe uncertainty. Frank Knight was the first to assert in 1921 that uncertainty was distinctly different than risk, which can be measured. Knight said, “It will appear that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.”
In the 17th century, prior to a voyage, risk and uncertainty were accounted for in different ways. A vessel was selected that was best equipped to move cargo in the fastest time while accounting for distance and route. The captain and crew prepared extensively for the journey and potential hardships. Finally, trade financiers and insurance companies assessed the aforementioned risks and factored in unknown risks during underwriting to diversify and hedge their firms against financial failure. Most of us are not embarking on a trans-Atlantic voyage on a wooden ship, but how can we address both risk and uncertainty in 2020?
Prepare for the worst
Risks you are unprepared for hit the hardest. Just ask any business owner who experienced 80% to 100% revenue declines in March and April or the engineers who designed the hull of the Titanic. A global pandemic was not a high-probability risk for any business or investment portfolio heading into 2020. When creating forecasts for strategic decisions and risk management, we assess the likelihood of potential outcomes and consider potential risks. We then implement a strategy based on these forecasted scenarios. Systematically, in this process, we underweight unlikely adverse outcomes, or “tail events.” Nassim Taleb’s book The Black Swan highlights the shortcomings of traditional risk management. The book notes that when unpredictable events that carry massive consequences occur, almost nothing else matters.
While we do not advocate preparing for a pandemic and an economic shutdown every year going forward, we recommend thinking about potential icebergs and what can be done ahead of time to mitigate their impact on your business or portfolio. The goal of the planning process is to avoid instances in which you are forced to make sudden decisions that prioritize self-preservation over long-term strategy. The focus should be on strategies that give you options and flexibility.
We adopted the policy of overcommunication in March when our business went virtual. It is the first and most important feature of our risk management policy, and it is something we will maintain following the pandemic. Giving everyone an equal voice to introduce current and potential risks has been integral to maintaining our operations, client service and workflow. Group problem solving has also helped improve parts of our business such as streamlining operations and introducing greater flexibility into employee workflows.
We used the same communication approach with our clients. By both asking questions and giving answers, we successfully managed through a very emotional and volatile period. We incorporated more education and thought leadership into discussions and meetings, and connecting personally on stressful COVID-related issues has reinforced and deepened relationships. As a customer of numerous vendors, the responsiveness and service we received during the spring will be a big determinant in earning our business in the future.
The uncertainty portfolio
For your investment portfolio, your asset allocation and approach to risk should governed by two key factors: tolerance of loss and time horizon. At the extreme, a portfolio 100% allocated to cash or low-risk bonds would limit downside and would be appropriate for an investor or business owner who may face liquidity issues in the next 1-2 years. However, much like insuring 17th-century merchant ships, negative real rates present a real cost to cash in portfolios. Therefore, a 100% cash position is not appropriate for a portfolio with a 10-year time horizon, which would seek a positive real return. Uncertainty induces caution, but what level of caution is appropriate currently?
Risk tolerances vary, but given the level of uncertainty, we recommend investors consider the following when thinking about their own “uncertainty” portfolio:
- Seek diversification over concentration. Idiosyncratic risk has overshadowed systematic risk in 2020. Specific industries are on the brink of failure while many broad equity indices are at or near all-time highs.
- Understand and plan for potential liquidity needs — personally and those related to your business. As we noted before, preparation will avoid forcing you to think short-term and will allow you to sleep better at night.
- Evaluate the risks outside your investment portfolio and adjust accordingly. For a real estate owner, a liquid investment portfolio should look different if properties are leveraged vs. held outright. Property type may also contribute more risk in the current environment and warrant more caution.
Risk mitigation was a driving force in advancements for merchant shipping in the age of exploration, such as the creation of the joint stock company. The current pandemic has caused a reassessment and improvement of the corporate strategy and risk management practices utilized by many businesses. For investment portfolios, uncertainty and the tail events of March 2020 revealed the shortcomings of some strategies but rewarded patient and prepared investors with tremendous opportunities. The current level of uncertainty will abate, but risk management will always be important. Taking the time to assess, improve and communicate the risk management approach you use for your business and portfolio will contribute to longevity and success.
Erich M. Hickey, CFA® is chief operating officer and chief investment officer at Drexel Morgan Capital Advisers (drexelmorgancapital.com).
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