Consider the difference between two ways of managing risk:
Static: ‘set it and forget it’.
Dynamic: respond in real time.
Almost everything we do falls into one of these two approaches, though we may not be conscious of it. Roasting a chicken? Mainly type 1. Making up a new stir fry recipe? Probably type 2. Buying car insurance? Type 1. Driving a car? Type 2.
So far, so good. Some activities require a degree of real-time attention. It might not be a high degree of attention, but it does require some. You’ll taste the stir fry along the way, check the chicken pieces are cooked through. You’ll stop your car at the red light.
This distinction really starts to matter when we realise that there are some domains which we treat as if they’re type 1, when really they’re type 2. For instance, sincere parents may be keen to read all the parenting books they can, and get their parenting approach as perfect as can be. This is type 1, the desire to create a perfect system which can then ‘run’. In reality, parenting is mostly type 2; it’s about responding to unpredicted crises, opportunities, conversations, and challenges. All the preparation helps only in so far as you’re equipped for real-time response.
Another huge area where this comes into play is investing. Investors keep pursuing the ideal of a ‘set it and forget it’ portfolio; one which, once you’ve invested the right amounts in the right assets, will just run and make you rich. Yet, even if we could all agree on the ‘perfect’ ratios of stocks, bonds, and commodities to hold in a portfolio, we would still be left with real-time decisions to make. And those real-time decisions will actually prove to make all the difference. This is type 2 risk management, not type 2 - whether we like it or not.
For instance, two people may have the same portfolio. They start out holding the same amount of, let’s say, gold, bonds, and stocks. A week later stocks drop by 20%, and gold rises by 30%. Now what? A month later, stocks are down 40% and gold is up 60%. The set it and forget it approach wants to say, ‘rebalance’! In other words, re-set the portfolio to what it was when it started. The problem with this is, how quickly, and how often, should you reset it? Monthly? Weekly? Yearly? Already we’re into real-time decisions. The first person may opt to do nothing. The second person may have sold stocks once they were down 10%, and sold half of their gold when it was up 50%. In that case, the second person is considerably wealthier than the first, after just a month. The point is, we can think investing is a set-it-and-forget-it (type 1) game, but really it’s a decisions-in-real-time game, even if you’re anchored to a set it and forget it model.
One book which makes this point profoundly helpfully is The Art of Execution. In it the writer, who had hired a large team of fund managers and given them a more or less free hand over how they managed their funds, reports that the managers who made the most money overall actually picked a losing trade more than half the time! Read that again. In other words, all their success was down to real-time decision making. There’s the initial decision to invest or not, and then there’s the ongoing decisions about how you will manage that holding. Will you hold, sell, or sell some, or buy more, or what?
At the time of writing we’re putting together an investment training tool drawn entirely from antifragility principles. This principle of real-time execution runs through each aspect; how to allocate hyper-conservative assets, how to choose hyper-aggressive assets, how to hedge against tail risks, and so on. Note that these real time decisions don’t have to be complicated - in fact, the simpler, then better. But they do need preparing in advance. If gold drops, at what point will you sell? If the market crashes due to war, at what point will you take the profits from your tail risk insurance? And so on.
We’ll pursue this theme further in subsequent articles. Let’s wrap up by summarising; let’s not chase the mirage of ‘set it and forget it’ approaches. For anything involving real life (and people), we’ll almost always need decisions made in real time. It tends to be the ‘art of execution’, based on simple, pre-prepared rules, which makes all the difference over time.
Photo by Declan Lopez on Unsplash