I first learn the term “unthinkable” from an interview made by WealthTrack with both Bill Gross and Mohamed El-Erian late last year. It isn’t a new concept. We have a wide range of names that cover a part or whole of the concept such as “Worst case”, or “Unexpected case”. Yet, very often we fail to do the real thinking behind or to actively look for those cases. In a question like: What are the 10 unthinkable events to happen to your life? (implied: and how will you deal with them?) – I don’t think most people would have an immediate clear answer, or at least a generally systematic approach toward those worst cases (worst case with the s at the end).
I know saying things like we are living through an extremely interesting period with a lot of structural changes sounds so much cliché. But it really is. 2010 Flash Crash, 2010 Middle East’s Spring Arab, 2011 US’s credit downgrade, 2011 Swiss Franc safe-heaven status denying, 2011/2012 EU debt crisis intensification with a storm of credit rating cuts, 2012 Japanese Yen monetary structural change toward inflationary (a policy that was unfamiliar to Japanese economy for at least as long as 30 years), and US current debt paramount incorporated with serious fiscal problems (probably the next big thing) are kinds of once in a life time event. We can also take a step back and look for a larger, even more structural movement: the world once belong to EU from 15th to 19th and US from 19th to 20th is now slowly revolving toward Asia. If Asia is not the case, then perhaps the world is revolving toward a new elite club with members from all over the world: from Brazil to Middle East and China in a multi-polar power world. Questions such as “Where are you from?” are then changed to “Where did you graduate?”. Terms such as “Asia Ex-Japan” and “Third world countries” are shrinking and terms such as “frontier countries” and “emerging countries” are expanding. New technologies puts old industries to history at a never faster pace (and guess what’s the next big thing is even a much more difficult work). Take a further step back, I realize how important it is to be humble and acknowledge my limitations.
It can be exceptionally costly to marry a wrong idea. It’s equally costly to stick to a no-longer-working theme or jump into an anticipated-but-never-come theme. In the context of liquid investments such as listed equity, foreign exchange, and commodities, volatility also plays a large part to make a theme become so difficult to see. Corrections now seem more fierce. Trading range significantly widens since just 4-5 years ago (especially in foreign exchange). Correlations from markets increase substantially as investors (mostly from developed countries, especially the US, EU, and Middle East) face pressures of diversifying outside traditional domestic equity and bond markets to find a better yield. Sovereign funds now play a larger and more influential role in foreign exchange and precious metal markets. The conflict of interests between major forces from both economic and political perspectives (eg: China, US, and their allies; NATO, Israel, and Iran; North Korea’s nuclear issue, …) becomes more profound and complicated. In such a world, room for being right is tight and room for being wrong is enormous.
As I often said, the more I know about finance, the more I see it centralizes around risk management. There are some explanations for this tendency. Firstly, every financiers should be a strong believer in compounding interest. Given the advantage of compounding interest power, it would be unwise to deny its power and commit some uncalculated risks. At least, a prudent investor should only take risk for undiversifiable parts with a risk premium over the risk-free rate (CAPM and APT). Secondly, I see inflation is typically an unjustified explanation for investment, even though arguments for hedging inflation are becoming hotter these days. Downside risk of investment is much larger than inflationary risk alone. Besides, there are numerous sound financial instruments, such as Treasury Inflation Protected Securities (TIPS), protect both credit default risk and inflation risk. Interestingly, I observe that in developed countries with typically low inflation such as US and EU, investors are more conservative and worried about inflation comparing to a less developed country such as Vietnam. In Vietnam, inflation is much higher, even double digits some years, however, individual investors almost do not care about inflation much from an investment stand point except for how a CPI number would affect to returns in stock price in the short-term. Thirdly, there is a huge shift in Wall-Street toward understanding risk better after 2007/2008 financial fiasco, especially quantitative models and structured securities. From an older and deeper perspective, since 1994, US’s National Conference of Commissioners of Uniform State Laws enacted its Uniform Prudent Investor Act required trustees (who managed others’ money) to “…incorporate risk and return objectives…” and “…duty to diversify the investments…”. Clearly, even the law governs financial industry states that investment is central around risk management.
Given the importance of risk management, yet from my limited observation, most retail investors lack a sufficient care about this matter. First, a very limited number of retail investors I know have a clear taste on their investment. Not mention to an informal and personal Investment Policies Statement, even a clear taste (large cap, small cap, value, growth, real estate, currencies, commodities, …) with clear reasons for competitive edges (investment expertise, network, information, specific industry understanding, …) in why investing in a particular asset or asset class is often overlooked. In Vietnam during 2006-2011 period with a typical boom-burst economic cycle, I personally observed many persons got quick rich in the first half and lost everything in the second half. There are two exceptionally repeated ways from my observations why people lost in the second half: (1) Got excessive confident, increased leverage, and expanded business/investment to totally new territories/areas out of their experience such as real estate and gold. (2) Increased leverage from great bull prior 2007 and failed to get out of a crashing market. Some got it out at the peak, but then got back again in the middle of the fall. I think, beside public psychology, one way to explain why a typical investor failed so hard in these extreme situations is that she lacked a systematic risk management practice. She lacks a point where her risk management system tells her that she needs to step back and re-access what she believes, asks some difficult questions, draws some unthinkables situations, and reduces market exposure. I believe that from a systematic perspective, no investment lesson is worth a whole wealth. There should be no “all-in” in investment field, and risk should not be managed in a case-by-case fashion.
So, if largest institutional investors in Wall-Street are returning to their own risk management models, why do each individual retail investor not build for herself an IPS or a risk management system? The question requires numerous efforts as well as trials and errors. Yet in this kind of world with many unthinkables, be humble and know where to acknowledge that we’re wrong can very well be a make-or-break experience.