Risk and uncertainty in the investment management business
What distinguishes a successful entrepreneur from her less successful counterparts? If you go back to Frank Knight’s classic work “Risk, Uncertainty, and Profit” it is the ability to successfully deal with uncertainty.
Knight differentiates between risk and uncertainty. Risk for him is a set of possible outcomes with known probabilities and known effects. The outcome of these situations cannot be predicted because they are random, but there is a quantitative way to express probabilities of outcome. Insurance contracts are a classic example of these situations. While it is impossible to predict when an individual will die, it is possible to predict the average life expectancy of a large enough group of individuals. Thus, if you pool enough individual life insurance contracts, you can price them in such a way that on average, the insurance company will make a profit.
Uncertainty, in the definition of Knight, on the other hand, is defined by the lack of known probabilities and outcomes. This is what entrepreneurs must deal with. They know the market for the product or service they have created, but they do not know how many customers will buy the product, at what price and how competitors will react to the introduction of this new product. And while one can make educated guesses through market research, the fact is that there is no probability distribution for the success of new products and no way to know how competitors will react to your new product. Running a business is beyond what risk managers can do.
This also has applications to finance and investing. Investing is obsessed with risk management, and for good reasons. We are blessed with reams of data that allow us to estimate the probability distribution for future returns of different investments. We still get it terribly wrong all the time, but my guess is that thanks to risk management we at least get it wrong less often than in days past. Just look at the frequency of financial crises and significant economic downturns, which has declined dramatically in the last 100 years, the Global Financial Crisis notwithstanding.
However, the focus on risk management has increasingly made us forget that there are circumstances when we must deal with uncertainty and when a focus on risk management can be detrimental for performance.
Imagine a fund manager who evaluates a quantitative investment strategy. The focus on risk management creates a focus on what statisticians call a Type I error, i.e. the error of accepting a hypothesis as true when it is false. This is the big risk of data mining and backtesting. Investment strategies can look great when parameters are fine-tuned or looked at through a rear-view mirror, but perform poorly in real life.
What gets forgotten is that there is also the possibility of a Type II error, i.e. the error of rejecting a hypothesis as false when it is true. This is a particular risk in research and development activities. When developing a new product or trying to improve an existing product or investment strategy, an excessive focus on risk management can mean that new untested strategies and products are left on the wayside because there is not enough statistical evidence that they create alpha or there seems to be insufficient investor demand to make the product a success.
Good research and development needs people who are willing to take risks and have the ability to fail without causing too much damage to the organisation overall. The problem is that sometimes, research and development activities are dominated by people who are unwilling to take sufficient risks or focus too much on crossing the t’s and dotting the i’s when they should instead be bolder in their approaches to new products and investment strategies. Whenever I hear someone say that a new product will not be put out in the market because investors are not interested in it, I am tempted to throw the famous line – often attributed to Henry Ford – at them: “If I had asked people what they wanted, they would have said faster horses”.
Successful entrepreneurs know that asking your clients provides you with valuable insights, but clients typically do not have the imagination to come up with a truly high alpha investment strategy or a successful, truly differentiated new investment product. If they did, they would most likely not ask you for help anyway.
Research and development teams that are only trying to replicate what others have done in the past (maybe with a little twist here and there) are not only unimaginative, they are putting a company or a fund on a road to failure and obsolescence. So many hedge funds invest in similar strategies that specific trades become so crowded over time that there is no more alpha to be gained. And when things go wrong, they go horribly wrong, because many funds are trying to unwind similar positions at the same time. Similarly, if all your new products are just repetitions on an existing theme that competitors have piled in already, then you are trying to squeeze an orange that has already been juiced. How is a company supposed to develop new markets or grow its revenues with such a research and development team?
One of the best books on entrepreneurial success I know is Youngme Moon’s “Different”. In it she describes how Red Bull became successful because it ignored all feedback from customers about its products and how Google became successful by radically changing the approach to internet search. In the new book “The Four: The Hidden DNA of Amazon, Apple, Facebook and Google” , author Scott Galloway also emphasises how these companies encourage their research and development teams to try out new things. They run tiny experiments on their websites all the time and Amazon has even registered patents for flying warehouses and systems that protect drones from attacks by bow and arrow. This might sound outlandish but remember that a little more than ten years ago we did not have iPhones or Facebook. Because these companies were willing to take on uncertainty (probably ignoring any risk managers in their companies if there were any) they could reap massive rewards. The companies that came after these innovators tried to copy the big four but never managed to truly challenge them – and eventually disappeared from the market.
If you are running a business and you don’t have people who are willing to fail or you don’t provide the space for people to fail, chances are that after a while the entire business will fail.