Get a complimentary financial planning review meeting with a true fiduciary. Click here to get started.

Two Types of Risk: Tail-Side vs Volatility

Two Types of Risk: Tail-Side vs Volatility
Image by: Lucky

In the world of managing wealth, there are two primary risks to look out for

  1. The risk where everything is going great until you suddenly lose big: let’s call this tail-side risk.
  2. Risk of fluctuations in the value of what you own - volatility risk.

Let’s use a simple non-investing example to portray this: car prices go up and down all the time in the secondary market, and can be affected by factors like supply and demand for the specific car, the car size, or cars in general. That speaks to the second type of risk, value volatility. However, there is also the risk of your car getting in an accident and getting totaled, losing all the value of your car overnight; hence why we all buy car insurance.

Same example can be used for houses, bonds, equities, or any individual asset. Things like house insurance traditionally exist for the first type of risk, with the whole insurance industry existing to protect against tail-side risk.

The second risk however is something intrinsic. And it is the cost one must take for the reward of higher returns. Let’s look at an example: after years of hard work, Idris has established a well-run large clinic that is generating a handsome annual return. This is his jewel asset and he would never think of selling it. To diversify his risk away from his concentrated networth exposure to the clinic, Idris takes the income from the business and invests in diversified investments elsewhere (with no intention of selling this asset). Let’s now assume that an investment banker, Mark, really wants to make a deal where he gets investors to buy Idris out; Mark leaves an envelope every day on Idris’s desk indicating the value for which he can get the business sold for. At first, due to curiosity, Idris opens this envelope every day, and finds a slightly different number each time. Let’s assume a global pandemic now happens and uncertainty of future outcomes shoots through the roof. Mark, however, is still leaving an envelope on Idris’ desk—should Idris open the envelope to see the value of his business? Most non-sadists would not, as they would know that this would be the worst time to sell the business they worked hard to establish.

Idris opens the envelope to see that the number is 30% of what he has become accustomed to seeing, which shouldn't come as a surprise. Regardless of the shock factor, it is quite concerning and has caused Idris a large amount of anxiety. Idris cools down, thinks of the situation, realizes that he wasn't going to sell his business anyways and focuses on what matters most, running the company. He stops opening the envelope on a daily basis, and sends them directly to the shredder. Years pass, everything cools down, and not to his surprise, he opens the envelope to see that the price investors are willing to pay for his business has gone up over and above what he was at first accustomed to. He smiles happily knowing that his dollar valuation of his net worth has gone up, but remembers that this doesn't matter as he is not looking to sell.

The above example is so close to reality in private markets, though for some reason we don’t think of public equities the same way (even when it is the exact same concept). Public equities are essentially legal ownership to companies where there is constant price discovery due to exchange traded liquidity. We have gotten so accustomed to seeing prices that we started believing that this is the true value of investing (trading), instead of remembering the essentials that Idris did in the example above. Volatility is natural, and it is something we have to accept if we want to own real assets or anything that is not pure USD cash or whatever currency we price our net-worth in.

The main risk to look out for is not short term value volatility in USD terms; the one that should keep allocators up at night is definitely the tail-side risk, as this is the one that can really hurt in the long term. Idris realized this and made sure to create a second pool of diversified assets to ensure that if anything happened to the clinic, he would have preserved diversified assets elsewhere he could rely on.

Diversification is by far the best way to hedge against the first risk when managing your wealth. During the pandemic, many industries, such as hospitality, travel, and leisure, were significantly impacted by government-imposed lockdowns, travel restrictions, and other measures to contain the spread of the virus. These measures had a negative impact on the performance of many companies in these industries, leading to significant losses for investors who were heavily invested in these sectors. On the other hand, investors who were diversified across a variety of sectors and asset classes were better able to weather the market downturn caused by the pandemic. For example, an investor who had a well-diversified portfolio that included investments in sectors like healthcare, technology, and e-commerce would have strongly benefited from these assets.

Up until recently, the majority of the Lebanese expat community were importing their hard earned savings back into the Lebanese banking system offering them very high fixed deposit rates on USD. A common belief amongst the entire community was that the banking system had never failed, even in times of war, and that the system has never defaulted on its debt. The lure of no value volatility derived from deposits was so high, that people chose to consciously forget about the first risk. In 2019, the country defaulted and banks disallowed high value withdrawals leaving most of the community with large losses.

Mostly, everyone who has accumulated wealth does not plan on spending it all within a few years. The majority of individuals would like to at least preserve the value of their assets whilst yielding an income or growing the assets further over long periods of time. This is reflective of individuals who have liabilities (need for their actual cash) long into the future. Hence, it is crucial to manage the assets in a similar manner, think long-term, and disregard short-term volatility as long as your assets are well diversified and fundamentally managed for your objectives, whether it be preservation with income or higher than average growth.