Mitigating Randomness – How to Protect Yourself from the Unforeseen

A few years ago there was a book that came out about what has been termed the Black Swan effect, essentially, the principle is this, just as someone can get lucky and win the lottery, we can also get unlucky.  The most obvious and accessible examples would be accidents where someone gets seriously injured or killed derailing major life plans.  The reality is these things happen in spite of our best efforts and diligence.  Who could predict for example the attacks on 9/11?  If you’d purchased the stock of a company head quartered in the top section of the World Trade Center towers that investment might be worthless when the markets reopened after the attacks.  So how do we protect ourselves from this?

Randomness should be a part of projections

All too often the problem starts by not considering randomness in the calculations.  Consider for example someone who purchases a rental property but doesn’t budget for vacancy, the reality is eventually it will come, how severe is up for debate but rent enough properties long enough and eventually you’ll have to shoulder the costs during months when you have no tenants.  The same is true for maintenance costs and property damage, you can minimize the odds but on a long enough timeline they’ll show up.

The same problem is true when average people make financial projections, it’s very common to hear financial advisors pitching investments with 20+% returns as beating the stock market that’s averaging 9%, the difference is the 9% accounts for the losses over that time period, the 20% doesn’t account for the probability of loss.  Here’s an example:

  • Say you’re being pitched an investment with a 20%/yr. projected rate of return (you should be immediately suspicious if you are because that’s a hard return to offer, in fact Warren Buffett only averages 20% over a long period)
  • Say there’s a 10% chance of a 100% loss in that time period
  • What is your real rate of return once you calculate the possibility of loss?

Answer: 10% chance of a 100% loss means you’ve got a real loss over a sufficient scale of 10%, meaning the real rate of return is only 10% not 20%.

Of course the real challenge is calculating what the probability of loss and severity of the loss will be to account for it.  The first hint in what to do is always recognize that there is a chance of loss so you need to be factoring that into the calculations.

Always recognize there is a chance for loss

There are essentially four ways to mitigate this randomness:

  1. Diversification/Asset Allocation – instead of putting all your money into one investment, spread it out between a few, instead of just one investment class pick a few (for example bonds and stocks)
  2. Scale – averages are actualized across large scales in other words you can’t pick any one house and predict accurately the maintenance costs as a percentage of the market rents but you can with a fair amount of accurate across a large number over a long period of time, sticking with it and investing over a long period of time and a large number of moments, even in the same field will limit the effects of randomness (you won’t be unlucky every day or year)
  3. Insurance – for many forms of randomness there is insurance available, this isn’t generally true for all cases and often the insurance isn’t worth the cost because the risk is too minimal and calculating the odds is too difficult but it’s an option for many scenarios
  4. Structure – while not an option for most people in most investments it’s possible to design structures where your downside is protected if not eliminated such as partnership arrangements, etc.

While eliminating risk entirely is not possible being aware of the risks including the risks of randomness will help you to avoid them.

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