By Brad Thomason, CPA
Human beings do not do well when they have run-ins with cobra venom. This is a universal truth. Cobra venom is highly toxic no matter what your home town.
That said, folks from Helena don’t have as much to worry about as folks from the outskirts of Mumbai. It’s not that a Helenite (is that what they call them?) is immune to the effects; but rather that cobras are in pretty short supply up in Montana.
When we look at risk from the investment perspective, it is more useful to look at exposure than the elemental aspects of the thing that can go wrong. While this may seem like a strange statement, it is something that you already do in other aspects of your life, perhaps without even realizing it.
When we bring electricity into our homes, we do not change the fundamental nature of the electricity; rather we put in place counter-measures to limit how much it can hurt us if something goes wrong. We make it workable without removing its innate dangerousness. Ditto with fire. The eyes on your gas cook-top are not 36 inches in diameter for a reason.
When we talk about exposure we are talking about the combination of incidence and impact. Incidence is how likely the negative event is to occur. Impact is the degree of damage it will cause if it does.
Again, people in Montana don’t have to worry about cobras as much because there aren’t any cobras around, in the first place. The incidence is sufficiently low that the risk is essentially nullified. The exposure is pretty much nonexistent.
In portfolio design, we accomplish a similar result through the way we allocate capital.
If you asked most people whether or not trading derivatives is too risky an activity for a retirement account, I think most people would say it is.
But I also think you could make the case that I didn’t give you enough information to answer the question.
If two people had a million dollars in savings, but one had $20,000 in a trading account, while the other had $400,000, wouldn’t we have to regard that as two very different scenarios? In the end, the part that would draw our attention would not be the trading itself, but the amount involved, right?
It’s very hard for the $20,000 we have walking around in the Indian countryside to hurt the $980,000 we have stashed back in Montana, so to speak.
Risk is a sufficiently important matter that we should understand it thoroughly, and that includes an understanding of a particular thing’s fundamental potential for destructiveness. But we should also understand that fundamental potential is largely theoretical. In practice, our exposure to the risk – not the risk itself – is what we need to be thinking about. How likely it is to happen, and how much it can hurt us, are what will impact our actual results.
The sun may be a fire so hot that it is basically a floating nuclear reactor. But knowing not to take the kettle off the stove and pour the contents on your hand is a more useful tidbit for making it through the typical day.
If this were an episode of Seinfeld I would figure out some way to end this post by serving tea to a cobra, or something like that.
But it isn’t.
So just keep in mind that your exposure to risk is what matters; and that one of the primary ways to control the exposure is via capital allocation. OK?
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