With a winter blizzard swirling outside, it’s a good day to adopt a lesson from my last Caribbean resort experience into the curriculum of the MBA course on Risk Management that I will teach later this month.
The context is certainly rich: between the collapse of Bernard Madoff’s investor scheme and the revelation that Satyam Computer Service’s balance sheet was a work of fiction, effective risk management is once again found wanting on a broad scale.
So there is relevance both for students and to the theme of my usual writing -- the challenge for investors and other users of financial information to find reliable guidance for their decisions, especially in the current troubled state of the worlds’ capital markets.
In a blue-water lagoon during a recent school holiday, I had a near-disaster in my quest to obtain my scuba diving certificate. I had a surprise equipment failure on my very first dive. A calm and beautiful undersea experience was turned in an instant into scary and airless gasping.
Back on the boat, having survived a breakdown that had not ever occurred in the experience of our captain, the dive master or any of her students, I was in a state of high-adrenalin calm. I hope never to repeat those intense and time-frozen moments. But I was ready to go back down again.
Why?
First, life is full of contingencies. If I had ignored or disrespected the pre-dive training that provided me with the hand signals to communicate my distress – if I had been too deep to be able to surface on my own depleted lung capacity – if I had yielded to the urge to panic – the result could have been dire and I might not be writing this at all.
I have written – here – on the importance of comprehending the importance of those unpredictable but highly consequential events that occur much more frequently than we perceive: October 1987 -- September 11, 2001 -- Long Term Capital Management -- Virginia Tech. In his eponymous best seller, Nassim Nicholas Taleb calls these the “Black Swan” events -- the very ones that cannot be anticipated, but that have disproportionate influence in our lives.
Users of any system designed and operated by human beings – whether a diving apparatus or a subprime mortgage derivative valuation model or a corporate audit – have the responsibility to know of the non-zero risk of failure.
Although it is the essence of random events that they cannot be predicted, their possibility does give the chance to think ahead. Pay attention to your dive master, the better to cope with an accident. Wear your seatbelt, to avoid becoming a traffic statistic. To reduce the chance of lung cancer, stop smoking.
And to avoid a collapsed portfolio, don’t put all your investment eggs in a basket woven out of improbable stories, untestable strategies and irrational enthusiasm (Mr. Madoff, q.v.).
The liability release form that I had signed, back on the dock, was miles away from my thoughts or any possible influence on my reactions, fighting off panic at a depth of twenty feet just above a reef. The reality of high-stress experience is disconnected from the compliance requirements of licensing authorities, regulators or politicians.
Instead, an effective approach to unpredictable hazard is to mitigate the risk directly through research and preparation. Rehearse the divers’ emergency procedures. Pay attention to the flight attendants’ safety speech. Get a second opinion to validate an initial cancer diagnosis. And get better investment advice than available in the country club’s locker room.
Another is to measure and manage the downside consequences. Don’t dive deeper than experience supports. Allocate investments under a managed plan; the long-term requirements to manage a retirement or a charity’s endowment make them a poor place for excess concentration or exotic long-shots.
As a beginner, I’ve got no more competence to do deep-water salvage diving than I do to trade foreign currency derivatives. If I tanked in either one, I would deserve the consequences.
The lessons from my underwater accident should not be pushed too far. Life has risks, and they can’t all be eliminated. Who can tell how any of us would react under other kinds of sudden deadly threat – an icy night road or a gunpoint robbery or exposure of a giant corporate fraud scheme?
But as I learned under the sea, about the combination of advance preparation, calm at the crisis point and plain uncontrollable luck, the first two are subject to our individual influence and responsibility. And they will affect the outcome, whether involving a blown air tank or a blown portfolio.
I intend to keep diving, just as I intend to keep investing. In either case there is a non-trivial chance that I might end up dead in the water. But if so, it won’t be for reasons within my own control or responsibility.
Over the months I have shared experiences supporting my course’s core proposition – that improved choice-making is possible, even under turbulent and threatening conditions, through awareness of the avoidable traps, biases and errors – examples here, here and here.
This being a large and open topic, I invite your suggestions for my students' benefit of other “teachable moments.”
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