FROM RISK AVERSE TO RISK AWARE – PART ONE

26 August 2013


I’ve been told (too) many times that Trinbagonian and Caribbean investors are risk averse. The assertion is usually made with an undertone that almost implies that we are born with an aversion to risk, along with innate wining skills.

 

 

I disagree. Everyone in or from the Caribbean cannot wine … But, I won’t name names due to my strict no-snitching policy.

Taking a wine can be a risk too! 

I believe that many investors in ‘Trinbago’ – Trinidad and Tobago, and our region are not risk averse per se, but rather, they are not risk aware. Specifically, there appears to not be enough awareness on the difference between risk and uncertainty, which are two different things.

In this post, I hope to shed some light on the difference between the two ideas, and continue the discussion on different ways to define, measure and analyze risk in future posts.

CASE IN POINT: CL FINANCIAL / CLICO

The CL Financial / CLICO (“CLF”) story should be familiar to all of us.

It is difficult to make a call on whether CLF was pursuing its activities in bad faith or fraudulently, but I’d rather leave that to the authorities as I was in proverbial ‘short pants’ when CLF was in its prime. What is well established is that for some time, CLF provided high rates of return on some of their investment and insurance products.

CLF used the cash flows from its insurance and other businesses, supplemented by large-scale borrowings and other debt, to finance moderate to relatively high risk acquisitions and projects. Cash flows from their investments would then be distributed to pay policyholders and investors. A large portion of the returns were generated by reinvestment of insurance premiums, into local stocks (Angostura, Republic Bank, Flavorite, others), other insurance companies (British American), real estate (HCL) and petrochemicals (Methanol Holdings, Caribbean Nitrogen, etc), among a variety of other sectors.

Cash flow and income from one investment would increase the capacity to make additional investments and take on additional debt, which in turn would generate even more cash and income. CLF’s expansionary period coincided with a real estate and commodity price boom that helped boost returns tremendously, enabling its quantum leap from a major insurance firm into a multi-billion dollar conglomerate, and creating an ecosystem of millionaires inside and outside of the company.

It worked superbly, until it didn’t.

Commodity and real estate prices collapsed, followed by a global liquidity and credit crunch, and CLF found themselves in serious trouble having borrowed aggressively against assets and cash flows. One might be tempted to say that it is all obvious in hindsight, but looking at CLF’s business model and financial statements prior to their collapse, it was clear that the group was taking on quite a bit of debt-fuelled risk—which was compounded by very lax governance and complacent risk management, particularly related to commodity and property price cycles.

CONUNDRUM

If investors are so risk-averse, what enabled CLF to accumulate so much capital, from such a wide base of investors, to be redeployed into investments with elevated risk profiles?

CLF’s well established brand spanning decades, army of highly motivated sales agents, and existing client base did not hurt.

However, those attributes were not unique to CLF and are not a completely satisfying explanation for why supposedly risk-averse clients flocked in droves to the higher risk products within the CLF suite. Looking at Unit Trust’s and Guardian Asset Management’s product suites, they also have relatively riskier products that have not attracted the level of assets commensurate with their existing brand, sales force, and client base. So what was the difference?

One major difference was that CLF’s products delivered outsized returns consistently for several years before its collapse. In other words, once investors perceived that the returns were “certain,” and as confidence increased in the certainty of these returns over time, they were willing to turn a blind eye to the risks involved.

In fact, some of them may have been unaware or dismissive of the risks altogether. They simply saw returns and “certainty”—and not the risks being taken.

RISK AND UNCERTAINTY

“There are known knowns; these are the things that we know that we know.

There are known unknowns; that is to say, there are things that we now know we don’t know.

But there are also unknown unknowns—there are things we do not know we don’t know.”

— Donald Rumsfeld, United States Secretary of Defense (2000 – 2006)

 

Risk and uncertainty are often confused with each other, probably because they are related concepts. You can’t have risk without uncertainty.

The concept of differentiating risk and uncertainty was explored in detail by Frank Knight, one of the leading economists of the early 20th century who wrote “Risk, Uncertainty and Profit” in 1921, which went on to influence several generations of economists. Donald Rumsfeld, in his infamous statement from a 2002 press conference, encapsulates much of the book’s central argument; to paraphrase in Rumsfeldian terms, risk is the known (and quantifiable) unknown while uncertainty is the unknown (and unquantifiable) unknown.

“There is a fundamental distinction between the reward for taking a known risk and that for assuming a risk whose value itself is not known,” Knight wrote. He also argued that profit is the reward to the entrepreneur or investor for bearing risk and uncertainty.

Perhaps an even more important notion is that “certainty” itself is not certain. It is not absolute, but rather, exists in degrees. Lastly, risk and uncertainty are not static, but are dynamic and tend to fluctuate over time. Some risks fluctuate more than others, but there is always some degree of fluctuation. Therefore, it is important to realize that there is always uncertainty, and therefore that there is always risk.

PROCESS OVER OUTCOME

“Looking at portfolios, think deeply about process over outcome.

If you do something the right way enough times, you will win.”

— Dan Loeb, founder of Third Point LLC, a hedge fund with average annual returns of 25% since 1995

Investors seek certainty in large part due to a fear of making mistakes, which besides translating into a loss of capital, is heavily penalized psychologically and socially in our region.

However, being lulled into a false or misplaced sense of certainty may very well be the biggest mistake an investor can make, and could be considered the original sin of investing. This misplaced sense of certainty is what led to the massive losses at CLF, and what is currently leading to large (and increasing losses in the bond portfolios of many regional investors. It is worth repeating, emphatically: there is always uncertainty, and there is always risk.

The fear of uncertainty, and potential mistakes, leads to the outcome (making money or avoiding losses) being emphasized at the expense of Process, while I will define as a framework or set of frameworks on how to generate returns and make money from the markets, or how to avoid losing money when possible.

Process is the tool to overcome the fear of making mistakes, and helps counter the tendency to adopt a misplaced sense of certainty. Process is not a cure-all or a guarantee against losses; and of course, even while a risk may be quantifiable, it is never completely predictable. However, every successful investor, whether they are value-oriented like Warren Buffett, or speculatively-oriented, like George Soros, relies on Process to generate returns and mitigate risk.

Putting the outcome before the Process is not very different to putting the carriage before the horse. The horse is what will get you to your destination, just like the process will help you understand, measure and avoid undesirable risk.

That being said, Process or the development of Process is often hampered by a lack of confidence.

Earlier this year, I attended a meeting where several large institutional Caribbean investors were present, and where an animated discussion on what types of risks can be taken led to a larger discussion on what can be learned and what can’t be learned.

Many of the investors did not feel comfortable admitting that they did not understand certain concepts, or talking about where their current knowledge level is. Furthermore, many felt that they could not learn or implement the new ideas. In fact, that meeting was what led me to conceptualize this series.

My ultimate objective is to show that knowledge and learning is a fluid process, and to provide a familiar, local voice to a subject that can get very technical.

CONCLUSION

These implications about the nature of risk and uncertainty do not always appear to be fully front and centre in the minds of many investors in T&T and across the region. There have been many changes in the investment landscape since the turn of the century, and even more so after the global financial crisis of 2008 and its aftermath.

Bonds have been extremely overvalued for the past two to three years, and many investors have been forced to take risks they may not have otherwise. Additionally, interest rates are set to continue increasing from historical lows, presenting a typical rock and hard place dilemma. Bonds are actually the next big bubble poised to pop, and many investors have concentrated their assets there due to the same misplaced sense of certainty we discussed earlier on.

As these shifts in the market occur, hopefully Firstline can help you navigate these choppy waters. Please reach out to us at 868-628-1175 or info@nullfirstlinesecurities.com if you would like us to evaluate the risk in your portfolio, or with any other questions.

Michael J. Cooper

Consultant

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