There are three distinct sides of risk –
1.Odds of a phenomenon occurring
2.Average consequences of a phenomenon occurring.
3.Tail end consequences of a phenomenon occurring.
As this crisis and almost every decade we find our financial system being dominated by players who concentrate on the first two aspects of risk and not the last one. These funds like a few quant funds had risk party executed using low vol strategies which blew up even in the face of fed backstops.
These tail risk events don’t matter until they suddenly are the only thing matters as the market swings from purchasing power risk to principal risk. Now is there a class , textbook or special coaching that can allow you to think about tail risk. And the answer seems to be no because such a calculation is not rationally possible by the brain nor is it possibly computable in the fundamentally uncertain universe, we live in.
It is over here that experience or trauma matters because these memories can fundamentally reshape your risk aversion and perception through its effect on the hippocampus and Amygdala of the brain.
The author recounts his own experience where he and two of his other friends would go out skiing sometime in places that they weren’t allowed to as they were prone to avalanches. This one time he actually faces an avalanche that does not turn out to be life threatening but buries his feet in the snow , all the friends laugh it off but he was clearly shaken. The next time he went skiing again with his friends on being asked to ski the dangerous parts again , he unconsciously said no. The author makes the point that these unconscious decisions can affect our lives for better or worse , much more than the conscious decisions which fall into the first two categories of risk.
In investing, the average consequences of risk make up most of the daily news headlines. But the tail-end consequences of risk – like pandemics, and depressions – are what make the pages of history books. They’re all that matter. They’re all you should focus on. We spent the last decade debating whether economic risk meant the Federal Reserve set interest rates at 0.25% or 0.5%. Then 36 million people lost their jobs in two months because of a virus. It’s absurd.
Tail-end events are all that matter.
Once you experience it, you’ll never think otherwise
https://www.collaborativefund.com/blog/the-three-sides-of-risk/