Risk and Recovery

Greetings my delightful readers. I am happy to report that I am in one of the finest moods I have been in, in months and looking forward to sharing with you some of my thoughts on Risk and Recovery.

Don’t you mean Risk and Reward, Lawrence of America, you ask?

No, risk and reward has been covered to death and I will be discussing it only briefly here today. We all take risks in hope of achieving some reward in return, what kind of risks we take in return for what kinds of reward does merit a short discussion, but I think the more interesting and less talked about issue is how to recover from those risks that inevitably do not work out favorably and how to return to one’s optimal risk taking position from there.

What is the optimal risk taking position, you ask?

That’s a fine question, reader. May I say you are quite sharp today and looking good as well.

Most everyone is familiar with the concept of risk/reward. It is the cornerstone of the Capitalist economic system, it is what allows entrepreneurs to become disproportionately wealthy, it is what drives trade in the capital markets and fosters innovation around the world. Anyone who has ever been to a casino is intimately familiar with this phenomenon in it’s crassest form, but risk/reward plays out in almost every area of our lives, from our careers to the people we give our trust and love to.

When I was a Financial Advisor at Merrill Lynch, part of my job was to accurately assess the risk tolerance of a particular client, and construct a portfolio of investments for them that maximized their returns at that particular level of risk. Stocks are riskier than bonds, treasuries are even safer than bonds and by combining different types of securities you can create a portfolio of any almost any level of risk/return that you can imagine, with one important exception. You can never do better than the risk/return optimal curve. You see, at any given level of risk there is a maximum potential return that you can potentially receive, as well as a maximum loss.

For example, if I invest 100% of my money into ultra-high risk junk bonds, the best I could possibly do is get the high yield returns these risky securities offer, and have none of them default. That is the best possible case scenario, and it is quite unlikely because these bonds wouldn’t offer such high returns unless the risk of default was proportionately high. So perhaps, by creating a combination of other high and low risk securities, I can achieve the very same level of potential return, at a statistically lower rate of risk.

Does this make sense? I hope so, I fear I am possibly not explaining this as well as I could. The point is, at any given time, one should always seek to take risks that will give the most bang for the buck. OK let me simplify.

There are three basic types of people. There are those that despise risk and avoid it at all costs. There are those that seek to understand and master risk, and there are those that get high on the thrill of risk. These groups are not necessarily mutually exclusive as all of us are likely to fall into one category or the other in different areas of our lives, but for the most part the majority of people fall into the first category. The average person despises risk. Studies have shown that the average reward:loss ratio that will induce a person to take a risk is 2:1. That means if you give them a 50/50 chance of either gaining $2 or losing $1, most people will take that bet but not if you offer them the same probability of gaining $1.50 or losing $1.

This is, of course, ludicrously unproductive behavior. It is well documented human instinct to place a greater importance on the avoidance of pain than the seeking of pleasure, and yet those people in society we so often admire most have achieved their success by flipping this notion on their head. The technically correct answer is to take any bet that offers a positive expected value, that is to say that the probability of success multiplied by the reward of success is greater than the probability of failure multiplied by the punishment of failure. The popular game show, Deal or No Deal is a gorgeous example of just how out of touch with this very simple rule of success the average person is. People like Warren Buffett, however, have made careers out of taking any bet that will produce a positive expected value, analyzing which bets those are very carefully and doing so over and over and over. In fact, repeating the activity is the key to this strategy working, as losses only get averaged out in time. As is so often the case in life, a half-hearted commitment is a guaranteed failure.

So, if you were to ask Warren Buffet to take a 50/50 chance on losing $1 or gaining $1.01, he would take it, any day. Of course, this also operates under the assumption that your losses do not compromise your survival, an important distinction explored in the landmark finance article Beyond Markowitz.

But in addition to the potential loss of one’s ability to survive by risking more than they can really afford, what about the emotional difficulty of recovering from a loss? There are very few risks in life that are so clearly delineated as to be absolutely certain. The market of life snaps up these inefficiencies as quickly as hedge funds do on the Nasdaq, so the best we can ever do is make a sober assessment of our risk and then proceed boldly and with confidence. The downside is the maddening questioning upon a major loss of whether the system we use to assess our risky behavior is itself flawed. This is why Warren Buffett is famous for saying that the best investors are not necessarily that intelligent, but they are emotionally stable people.

Emotional stability is something that seems to come easy to Warren, and yet has never come easy to me. Like the athlete whose genetics are less than ideal, I have to put in a little extra effort to make sure I am making decisions from an objective and logical viewpoint, that also includes an introspective understanding of my own emotions and how those will play into the game. For me, it’s always been difficult to not take failure personally, or for that matter, success as well. I think such a key mentality to have is one of feeling blessed at all times and realizing that those things we lost are usually things we never really had, and those things we’ve accomplished are often more gifted than earned, if we are really honest with ourselves. And yet, we have to feel empowered to make our best efforts whenever we can, psychologists call this Locus of Control. A higher locus of control indicates a greater belief in your ability to influence your surroundings, which is a self fulfilling prophecy, but only up to the point that you are able to manage the disappointment of recognizing that there are some things that are truly and completely beyond our control.

For me, recovery occurs in a few stages:

1. Grieve

First of all, I think it is important to allow ourselves the time to grieve. Others will say that getting back in the saddle as quickly as possible is ideal, but I would add the caveat that you must be ready, otherwise getting back in the saddle too early will only slow your progress overall. We live in a culture that so often disregards the need for people to grieve, I happen to think there is absolutely nothing wrong with locking yourself in your room for a few days with all the lights off and eating nothing but ice cream until you actually feel like rejoining the world. The key is not to overindulge in this behavior, but to deny it entirely is also, I think, a mistake.

2. Think

At this stage I will start doing activities that are positive, but do not necessarily have anything to do with the loss or “repairing the sytem.” The key here is to allow myself time to think and regroup. Reflect. Reflection is being pushed hard by the leadership and management community as an often skipped step in learning and growth and I am inclined to believe them. Non-stop action is not always the way to go and sometimes it is important to take a step back and consider carefully what has occurred and what it means.

3. Destroy

I am not, necessarily, referring to literal destruction, but rather the destruction of expectations and a reality that did not come to pass and is not the actual reality. Destruction is a critical step to growth and creates space for new things. I think that after you’ve had the chance to grieve and reflect on a loss, the first step towards acting in the new you (as every loss creates a new, better you) is to destroy those parts of the old you that are no longer necessary. Notice that his must be done BEFORE you can rebuild anything in their place and often before you even know what you will be building in the new space you have created. The point is just to take a sledgehammer to the parts of yourself and your life that you don’t like anymore and be done with it. This is a humbling stage and often the most difficult for those around you, but it must be done.

4. Create

In this stage, you have the emotional capacity to act from your optimal place – that of gratitude, compassion and humor – the three forces that are the greatest tools of internal and external influence known to man. You can now freely accept new options and already you are starting to feel the power of the new you and see the loss as a great gift that will deliver many more rewards in the future by the improvements it forced you to do the system. That is not to say that the bet was ever a bad one or that the system was ever broken, but you have improved it anyway and now you are in a better position to make even better bets in the future.

Unfortunately, there will be another loss before long. Such is the life we are given, and for those of us that choose the path of excellence, even more so because we deal with a heavy burden of self imposed expectations. So keep in mind that your last loss is never your last loss, but open your heart and be free to act, live and love from the very best parts of yourself and know that you will be rewarded.

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2 thoughts on “Risk and Recovery

  1. I was waiting for a “Risk” metaphor from your favorite game, which we never played, though I meant to get over to you for a session. Keep at it Lawrence. Become a successful captain of industry and bring me over as a literary consultant, as I have a fascination with the diversity of Singapore.

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