## Monday, December 29, 2014

### Risk Analysis

“Now listen, you who say, "Today or tomorrow we will go to this or that city, spend a year there, carry on business and make money." Why, you do not even know what will happen tomorrow. What is your life? You are a mist that appears for a little while and then vanishes. Instead, you ought to say, "If it is the Lord's will, we will live and do this or that." As it is, you boast and brag. All such boasting is evil.”
James 4:13-16

As the song says, “Whoop There it is,” straight from my least favorite book in the New Testament. Always start risk evaluation with the understanding that you just don’t know. You have no idea what might happen tomorrow. Yet, you must plan for tomorrow because there will be a tomorrow if not for you, for someone you love.

The Bible also observes, “A good man leaves an inheritance to his children’s children.”

Here is a simple method of calculating risk based on what I learned in school many years ago.

When you propose a plan consider the possible outcomes, in crude terms risk can be considered the product of two numbers, the probability of the outcome and the severity of the outcome. Frequently a 1 to 5 scale is used, with 5 being used for the most frequent and the worst case scenario. Therefore risk can be evaluated on a scale of 1 to 25, with 1 meaning little or no risk and 25 meaning really horrendous risk.

For example: NASA calculated the risk of a Space Shuttle disaster at 1/100. However, there was a great deal of disagreement over this number. Even if this number was correct, it would mean that there would be a 15% chance of catastrophic failure in every 16 planned missions. For comparison, the risk of loss of life in a Saturn mission was calculated at 1/50.

Choosing a number for the impact of a shuttle disaster is pretty easy. The loss of a \$3.5 Billion vehicle and seven lives, live on international TV is certainly a five. However, what number would you put on a 1/100 chance of failure? Maybe a three? That would give you a risk number of 15.

Is that an acceptable risk?

This brings up the second problem in evaluating risk, you.

"It is said that if you know your enemies and know yourself, you will not be imperiled in a hundred battles; if you do not know your enemies but do know yourself, you will win one and lose one; if you do not know your enemies nor yourself, you will be imperiled in every single battle."
Sun Tzu

As you evaluate risk, you have to understand yourself. Even children exhibit wildly different perceptions of risk. One of my coworkers shook his head when trying to understand his son, observing that he was the only child in his kindergarten class who carefully packed his book bag before going to sleep. Needless to say, this child grew up to be an engineer. A little boy in our neighborhood wanted to grow up to be a stuntman. His mother was not comforted when told, “Don’t worry. Broken bones heal and chicks dig scars.” Both are true stories.

Based on almost 64 years worth of data, I know that I am risk adverse. I tend to overestimate the probability of failure and underestimate the possibility of success. Therefore I try to push myself out of my comfort zone, but not too far out of my comfort zone. I am currently holding somewhere in the neighborhood of 40% of my portfolio in equities. With the Case Shiller PE index at 27.43, I am concerned the market is overdue for a correction, but if the Fed continues to pump new money into the economy the market may continue to go up. I decided, in advance, after careful study, that for someone my age, a range of 40% to 55% in equities is the best I can do, since I just don’t know. If my holdings in equities stray too far from 50%, it will be time for me to rebalance.

Of course failure is not the only possible outcome that must be considered in your risk analysis. There will be a best case outcome, a most likely result, and a worst case scenario associated with any proposed plans. Often working through these possibilities, with or without assigning numbers, will give you the answer you need. If the worst possible outcome of a particular action is the same as the best results of a different proposed course of action, your decision is already made. This actually happened during my recent family emergency.

If the sale of some item, such as a share of stock, occurs without coercion in a transparent marketplace, it is by definition, a fair exchange of value. Even if investors are irrational and markets are not totally efficient (that is each participant in the exchange shares the same information) in the moment, over a sufficiently long period of time, a sufficiently diversified portfolio will produce predictable results with a high degree of certainty. Even if only a single equity is involved, the mostly likely outcome is the 7% to 7.5% return proposed by Siegel’s Constant. It is unlikely that you will loose more than ½ of your money in any single transaction unless you are betting on penny stock or a company teetering on the edge of bankruptcy. Who knows? You might get lucky and double your money in a couple of months. It happens. Most of the time all these outcomes are already contained in the price you pay for a share of stock.

Then are times when the outcome is inherently more important than the probability of an outcome. When facing another decision during my family emergency, the worst outcome was unthinkably horrible. One course of action had little hope of success and a great probability of a ghastly failure. The second course of action had little hope of success but the probable outcome was acceptable, a natural death without suffering. The third course of action (a lack of any action) would result in certain death. I choose the second course of action, leading to the predicted result.

I began a more philosophical exploration of this subject in Does God Play Dice with the Universe?

Does God Play Dice with The Universe

For better or worse, our universe contains an element of randomness. Perhaps it is one of the results of the fall. I don’t know. However, I do know that every day we must make decisions based on inadequate information. Every day we must plan for a future we can not possibly know. Fortunately, there are verses of comfort to be found in Scripture. We have not been left alone in a probabilistic universe. There is a God. He is present in His creation. He cares enough about mankind that the Christ’s sacrifice to redeem us from sin was foreordained before the foundation of the world.

And without faith it is impossible to please God, because anyone who comes to him must believe that he exists and that he rewards those who earnestly seek him.
Hebrews 11:6

Let them shout for joy, and be glad, that favour my righteous cause: yea, let them say continually, Let the LORD be magnified, which hath pleasure in the prosperity of his servant. And my tongue shall speak of thy righteousness and of thy praise all the day long.
Psalm 35:27-28