The Benefits of Preparing for the Unknown

While many investors may define success for their investment portfolio from a return-centric perspective, arguably the more important factor to focus on is risk mitigation. Once you’ve defined a way to quantify the utility function inherent in a risk-centric framework, then return expectations can follow. Otherwise, the strategy is at risk of being abandoned when the inevitability of underperformance surfaces. The problem is that risk is complicated and hard to qualify. Not only can it not be destroyed (only transformed), but the word takes on different meanings for different people.

This article by the Collaborative Fund explores why risk is a complicated subject, and why “the biggest economic risk is what no one’s talking about.” Therefore, “well-known” forecasts of potential risks, like the U.S.-China trade war and the U.S. election, aren’t what poses the biggest threat to the economy. Channeling his inner Nassim Taleb, Housel suggests that when “black swans” or the “unknown-unknowns” surface and people feel underprepared, their perceived vulnerability contributes to their irrational actions. While paying attention to known risks is a smart thing for investors to do, the experienced ones proactively consider ways to insulate their portfolios from unknown-unknowns. While Taleb has preached creating “anti-fragile” portfolios that grow stronger from economic shocks, Housel posits that starting with the proper assessment of risk from the building blocks of portfolio construction is how, as an investor, you can “give yourself a wide berth” - so as to not act irrationality when the unknown strikes. We would also add that global diversification from a multi-asset perspective will help to increase robustness in portfolio construction. Housel also theorizes that thinking of risk in the way California thinks of earthquakes is a good mantra to live by. While the emergency crews of the state have no idea when, where, or what magnitude of earthquake will arise, they are prepared to jump into action despite no specific forecast. The parallels with investment strategy are clear, as while we don’t know in what form or what magnitude risk will manifest itself, the goal is to have a plan in place (e.g., rules-based algorithms) so you don’t have to rely on judgment or forecasting when you are at your most vulnerable.