Sunday, April 3, 2016

Precautionary principle and asset management

Nassim Taleb is a forward thinker who is always pushing scientists to think more deeply about of the statistical distributions of data. His latest effort has been trying to have more scientists accept the precautionary principle in their thinking about risks.

Thinking of this principle places the focus on the risk of ruin. Investors are constantly facing risk as measured by the volatility associated with their assets positions and there is no shortage of good work on risk management. The really problem is whether the risks we face are actually measurable and whether not realizing this uncertainty may cause our ruin. Forget about the VaR in a portfolio. What matters is whether the risks of some unlikely or extreme event will cause permanent harm to the portfolio. VaR is a good indication of some measurable risks, but it is just a tool for what is  important in a thin-tailed or Gaussian world.

The idea of the precautionary principle - that if an action is suspected of causing severe harm, action should not be taken in the absence of near-certainty about safety - has significant importance on any global problem where there is a chance of ruin.

However, applying the precautionary principle to asset management seems very relevant given a low return environment. The probability of ruin for a portfolio is vastly different than the probability of ruin with respect to global event, but in the current world, it is possible that bad choices could truly devastate an investment portfolio. The precautionary principle for investment management creates a focus on the probability of ruin but perhaps with a small "r"  instead of a big "R". Ruin for your selected portfolio.

How does this apply to money management? With respect to leverage, risks are amplified hence the precautionary principle is more applicable for a leveraged portfolio. If you use leverage, incorporate caution. Do not take big leverage bets if there is not certainty about safety. If you bias toward precaution, don't take leverage. The same can be applied with alpha strategies, without safety and a true understanding of risks, do not take the bets.

The precautionary principle also focused on the fact that risk may not be thin-tailed but may follow a power law. If there is a chance for a fat tail, then diversification has be applied so as to eliminate the chance of a fat-tiled risk from ruing a portfolio. A fat-teled event could be a war, country bankruptcy, or a flash crash. All could create ruin if there is poor diversification.

Now, ignorance should not be an excuse for not taking action. The precautionary principle would suggest a careful reading of risks to determine what is know and what is unknown. If there are unknown risks, then no action should be taken which may invoke ruin. Stay away from fads and fashion and focus on explore ways of staying diversified.

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