Mathematics Of The Downside

Why Understanding Risk Intimately Is Key To A Meaningful Life

Take advantage of it now, while you are young, and suffer all you can, because these things don’t last your whole life — Gabriel García Márquez, Love in the Time of Cholera

People aren’t stupid. The problem is that our educational system has an amazing blind spot concerning risk literacy. We teach our children the mathematics of certainty — geometry and trigonometry — but not the mathematics of uncertainty, statistical thinking. And we teach our children biology but not the psychology that shapes their fears and desires. Even experts, shockingly, are not trained how to communicate risks to the public in an understandable way — Gird Gigerenzer, Risk Savvy

Times like these remind me of the following words from Baz Luhrman’s song ‘Everyone is Free to Wear Sunscreen:

Don’t worry about the future, Or worry, but know that worrying is as effective as trying to solve an algebra equation by chewing Bubble gum. The real troubles in your life are apt to be things that never crossed your worried mind’

The real troubles in our lives often come from the left field. We are left with no other option but to ‘deal with it’. Nonetheless, we humans worry a lot.

However, what if I told you that understanding a key concept intimately could change our lives? My life continues to become more meaningful the more I understand the concept of ‘risk’. One must never fear the ocean instead one must respect it. Similarly, one must also understand and respect risk. In this story, I try to explain risk because my intimate relationship with risk has led me towards a more meaningful life. Risk is essential to our lives. In order to harness risk, a framework to understand it is priceless. Especially now, when the downside seems limitless.

What Is Risk?

To me taking risk is a way of life. More formally, risk is what can go wrong. The Oxford English Dictionary cites the earliest use of the word in English (in the spelling of risque from its from French original, ‘risque’ ) as of 1621, and the spelling as risk from 1655. It defines risk as:

(Exposure to) the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such a possibility.

Very often, risk is always defined in monetary terms. However, in reality, everything we do carries risk. Crossing the street, drinking a cup of coffee, driving or simply doing nothing. Existence generates risk. Some risk is systematic i.e. affects everyone or the entire system. For example, if the entire market or everyone is subject to the same exposure, it is an example of systematic risk. Others which are more specific to individuals or only specific agents or industries are known as unsystematic or idiosyncratic risks. These risks can be tackled by individual strategies. However, systematic risk requires collaboration to mitigate.

The other key concept that goes along with risk is ‘probability’. A probability of an event happening is how likely is that event to happen. A zero percent probability means it will never happen. A 100% probability means it is bound to happen. However, real life swings between the two. A combination of exposure and probability can inform you of both what you will lose and how likely will you lose it.

An education in statistics or probabilistic thinking is key to harnessing risk. That education should be as mandatory as learning alphabets.Then again, there are events that are so unlikely to happen that they are beyond imagination. However, if they do happen, they can be catastrophic. For all other events, dealing with uncertainty is a life skill.

Symmetric and Asymmetric Risk

There are many kinds of risk. However, asymmetric risk is a very important concept to understand. Symmetric risk is like a mirror. The potential gain from the upside and the potential loss from the downside are same. For example, if I stand to win $25 from an event turning out the way I want it to and if I stand to lose the same amount i.e. $25 if things don’t go as planned, it is a case of symmetric risk.

Let’s take another example. I recently purchased a used car and I took out a loan to buy that car. In this case, I know that the risk I am running is limited to the difference between the loan amount and the car value. Lets say, the value of the car was $18,000 and I took out a loan for the value of the car plus a few warranties and freebies thrown in for $20,000. Straight of the bat, my risk is $2000 assuming I can sell the car for $18,000. Now, imagine the same car keeps incurring repairs and I don’t the extent of repairs the car will keep needing to work. In this scenario, I don’t know how deep my exposure is. This is a case of asymmetric risk. If it is hard to quantify the downside of a risk or if you think the downside is limitless, it is a great indicator to not take on that risk. In this case, one option is to sell the faulty car and ‘cut’ your losses by paying the difference between the car value and the loan amount which hopefully I can quantify and pay off.

Life, often operates on asymmetric risk. An asymmetric payoff (also called an asymmetric return) is the set of possible results of an investment strategy where the upside potential is greater than the downside risk. There is also a beautiful upside story to asymmetric risk.

For instance, lets say I took a loan denominated in Pound Sterlings for my education in the UK. In this case, my downside is that I don’t find a job in the UK and I have to return to India. I will have to repay the loan denominated in Pounds by my salary in Indian Rupees. Imagine, in this scenario, if I do find a job in the UK and I eventually become a citizen then the upside could be limitless. Once again, this is an example of asymmetric risk.

Asymmetric gains also explain why people use ‘leverage’ or take on debt. In finance, leverage, is any technique involving the use of debt (borrowed funds) rather than fresh equity in the purchase of an asset, with the expectation that the after-tax profit to equity holders from the transaction will exceed the borrowing cost, frequently by several multiples⁠ ⁠ — hence the provenance of the word from the effect of a lever in physics, a simple machine which amplifies the application of a comparatively small input force into a correspondingly greater output force.

Dreams are a case of asymmetric risk. The only thing you have to be aware of is how deep is the downside. If the downside is potentially limitless including the possibility of ruining your health, stay away. Then again, most people chase dreams out of emotion not logic. However, understanding asymmetric risk can help evaluate both the possibilities.

Preparing For Black Swan Events

As per Wikipedia, The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalised after the fact with the benefit of hindsight. The term is based on an ancient saying that presumed black swans did not exist — a saying that became reinterpreted to teach a different lesson after black swans were discovered in the wild. The theory was developed by Nassim Nicholas Taleb to explain:

  1. The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology.
  2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities).
  3. The psychological biases that blind people, both individually and collectively, to uncertainty and to a rare event’s massive role in historical affairs.

When it comes to ‘Black Swan’ events, I always trust two or more years of savings to help sustain my life. According to the U.S. National Bureau of Economic Research (the official arbiter of U.S. recessions) the 2008 recession began in December 2007 and ended in June 2009, and thus extended over eighteen months. By comparison, the Great Depression of 1929 lasted almost a decade in the US. It is extremely hard to imagine most people having that kind of savings but a two year minimum is a great start.

I am sure that ‘Pandemics’ cannot even be compared to economic Black Swan events. Human lives are more important. Although the two are related — a pandemic does cause severe economic losses. However, the first order of business is always saving lives. As per The History of Pandemics, pandemics have always been a constant fixture in civilized life. As science and medicine progress, many epidemics just last for 2 years. However, many others last decades.

However, the lesson we learn about uncertainty is that we will always have some ‘unknown unknowns’ i.e. things or events we are neither aware nor understand. Suffice it to say, we don’t have much of a game plan but to band together. Short of such unknown unknowns, taking care of your health and having at least two years worth of savings are key.

Not Everything Is Mathematical

While risk has always been treated as a difficult concept to understand, it really is not that complicated only if we try to simplify it. When the downside is so extreme that it puts life in perspective, understanding risk becomes glaringly simple although that is not a humane example to learn from or to quote. The best time to understand risk is when things are stable or when business is booming. It is only when the tide recedes that we know how exposed we are.

I am an artist by heart. I always thought it pointless to quantify things such as risk. Risk always seemed so abstract and alien to me. Maybe, it was my youthful ignorance. However, the events in my life forced me to start thinking about uncertainty more mathematically and to devise safety nets where possible — an insurance against a rough future.

To this day, my family always blames me for thinking too much about ‘worst case scenarios’ including Black Swan events. Perhaps, they are right. However, trying to imagine all sorts of things that can go wrong and developing a possible solution for them has always helped me be more optimistic about everyday life.

In fact, imagining downsides of my activities has become a daily habit. The only reason I mention my family’s perspective on my favorite thought experiment is to remind you to always live in the present — I have spent a disproportionate amount of my time imagining the future. In short, balance eludes me but my hope is eternal.

Also, I did not write this article to focus on economic risks or monetary losses. During a pandemic, health trumps money. I wrote this article to explain why an understanding of risk (particularly the downside) has helped me time and again. A good understanding of risk as a concept has helped me prepare for the worst of situations. Even so, there could be events which I admit I can never be fully prepared for. Also, risk is a very vast concept. I am thoroughly inept at capturing the full gamut of ‘risky behavior’. I tried to summarize my learnings in the hope that it inspires others to learn about and where possible quantify risk. In all honesty, this is what it comes down to:

First, there is nothing more precious than life. It should not take a pandemic to remind us of this truth. Unfortunately, sometimes all it takes IS such an event.

Second, health is more important than money, economic loss or a looming recession. A relentless focus on the health and well being of family, friends and self should always take precedence.

Third, as with many things in life, it is impossible to model the risk of life events such as your partner falling out of love with you or a pandemic you have very little control over. Human emotions and Black Swan events defy mathematical models just as true consciousness eludes Artificial Intelligence (AI). There are many risks in life that we cannot understand intimately using frameworks or mathematical models. For all other risks, we must try.

Writer @ The Intersection of Finance, Tech & Humanity. Stories of a Global Language: “Money”. Contributor @ Startup Grind, HackerNoon, HBR. Twitter@akothari_mba

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