Why it is important to think about consequences of low probability events?

How many times do we really think about consequences of events which have small probabilities?

Cliche of “negative thinking”

My fiance recently gave a job interview and the boss of that company gave her a lift back home. Now when she told me this, I said her to never do such a thing with a stranger again. Though then as usual she started saying me “You are a hell of a negative thinker. You always think negative”………..Now this is the cliche which I commonly hear when I tell someone that they may have taken the wrong decision. My viewpoint was that person was a stranger and may be he is the best person on this Earth but what if there is even 0.0001% chance that he was a worse person with the wrong intentions, the consequence would have been very dangerous. She had alternatives to take like uber or ola.

Now I obviously know majority of people are very good and there are very few people with bad intentions. But the consequence of taking lift with a bad unknown person can cost you your life.

This is the problem occurs many times when we do not think of consequences. Whenever we think of a small probability event we never think about consequences or ignore it saying “ This has never happened in past, it wont happen in future or in other words  we mean to say it is impossible  train ourself to not think sceptically.”

This type of human behaviour is dangerous and is like playing the game of russian roulette. Would you like to play a game where there is a gun with 1000 barrels, and there is one bullet in one of the barrels, and someone asks you to put a gun to your head and pull the trigger. If you survive he will pay you may be 100 crores. Will you take the bet?

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Now the probability of gun hitting is 0.1%, if you are right you will win but if you are wrong you will loose your life. Whatever be the amount given to you, you should never take this bet if you are fairly rich ( I mean you can afford basic human needs). But most people will take it.

In fact thinking about negative consequences helps you to prepare or plan for them. Yet we see a lot of examples of people playing russian roulette in life, businesses and markets.

Lets try to find functional equivalents of roulette in real life.

On the Road

Whenever we are driving on the road, how many times do we really wear a seatbelt? We will always find reasons to skip it. Though the probability of an accident may be small but consequences can be devastating. Yes wearing a seatbelt does not assure safety  yet it reduces our probability of a great loss, all other things remaining same.

Similar thing happens when there are just two seconds left for the red light to turn green. Normally everyone accelerates instead of slowing down. In order to avoid a two second delay we increase our risk by many times.

Entrepreneurs

Debt taken by a steel company is definitely riskier than taken by a consumer company. Yet when times are good entrepreneurs of steel (or any commodity per se) forget that times do turn bad too. If you analyse the major bankruptcies which happened in India recently particularly in steel industry typical common pattern of over leveraging appears. Like Bhushan Steel, Monnet Ispat, Essar Steel and many more. Yes it is very easy to say that the promoters took wrong steps but they are in fact humans majority of us would have taken the same steps. Consider yourself in a situation the steel prices have started increasing, there is an artificial scarcity in the market, suddenly your inventory is selling like hot cakes, people have started giving you advance payment for your product (steel), your returns are extraordinary, the media is glorifying you, you have suddenly started becoming rich and now the bankers start approaching you to take debt.(Talk by prof Sanjay Bakshi reference) Majority of people would like to expand and grow in such as otherwise your competitors will take the market share. It is very rare while taking such debt do entrepreneurs think of being wrong. May be the probability of going wrong may be low but if your debt is so huge that it will you being wrong will lead to your bankruptcy you are on the wrong side of the trade.

Another interesting example comes from a case way back.

In 1984, the price of oil had collapsed from high of $110 per barrel to around $70 per barrel. Majority of oil producing companies in Texas, thought this fall to be the same as the previous ones which they had seen in their lifetimes. Normally, during their lifetime whenever the utilisation rates of oil companies went to 70% in the past twenty years, the oil price started going upwards. This time majority of managers of the companies thought the same. Finally, the average utilisation rate went to as low as 25% and majority of oil companies went bankrupt. ( Dead companies walking – Scott Fearson). No one could have predicted such falls, but the point remains the companies which had thought of worse cases were prudent enough to not get wiped of the market.

Now do I mean we should never do business in commodity companies – no. I mean to say we should strive towards making ourselves and our business less exposed to single risk. How can we do the same? I will tell later, first lets see some functional equivalents.

Investors

What does typically happen to naive value investors which enter the stock markets? (I have to say with a heavy heart I did the same mistake) . Typically excitement about new stock which is researched leads to overallocation to a particular company without thinking about the risk involved. Now when all things are going good everyones happy, then suddenly a low probability event materialises and you suffer a permanent loss of capital. Think about investors in companies like DHFL, Eros Now. No matter how good your analysis you should never invest more than 10% in a single company, Particularly if you are new to investing. As your experience increases you may break such barriers. But typical new investors forget to think about risk.

This is what happens when I see people naively trading by taking leverage, they forget about the highly improbable events.  The formula for compound interest is

                                                         A = P (1+r)^n   (Where n is the time , r is the rate of interest)

Most people in their life are over focused on R. But excessive rate returns are highly unstable. Majority of people forget to focus on n in their life. If you have a low R but for a longer n it easily beats a high R. Most of the super high R strategies which traders or people target in their life they forget to think about the longevity and riskiness of such rates of return. Normally whenever we take leverage we increase our return if we are right, but we pay similarly if we are wrong, we always forget that our risk-adjusted return comes down it does not increase. Think if you can earn 10% by investing Rs.100. Now there are two people one is Mr.A who invests Rs.100 of his own while the other is Mr. B who takes Rs 90 loan from the bank (5% interest rate) and Rs 10 are his own.

Now when you are right Mr. A earns a return of 10% on his investment while Mr. B 55%. (Rs 10 – 4.5 interest). But what if you are wrong by 10%, Mr. A gets back Rs 90 while Mr. B is potentially bankrupt.

Key lesson which I have learnt in fund management the hard way is you need to pay to avoid risk. Yes everyone warns us that finance and airlines is a very risky business, the odds of failure are very high. Now if you have a rule of avoiding investing in such businesses you will definitely one time miss HDFC bank but you will too avoid majority of jet airways. HDFC bank is the cost you pay for avoiding risk. We know that having a reputed broker which may be little bit expensive is far safer than some local dodgy broker. The extra money you pay is the cost for avoiding the risk.   

Probable Solutions

Black Swans or highly improbable events which hit everyone. The key is not to predict them, but to build a robust system that can help you survive such events or even make one stronger from the ones.

1. Avoidance Rules

 

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Have certain avoidance rules. Exclude certain things or whenever you do improbable things allocate less portion of your capital to them, so that even if you are wrong you may not be wiped out. Do consider the prior odds (Bayesian thinking) of situations. There is a lot of human history to warn us. Consider then prior odds and then analyse the new situation deeply. Allocate your capital or resources prudently. There is a lot of evidence that we forget to consider prior odds of any situation. Think of restaurant business or any commodity business, the prior odds or the average for such businesses is failure. Now when you invest in such businesses think what you are doing really differently or else you’ll have the average outcome .i.e failure.

Think about marrying to change some person. Now the average odds for such a situation is failure. Before establishing a new relationship to change some person think is this situation widely different from all the normal or average cases.

2. Build layers of Safety

Debt by its nature makes one exposed to highly improbable events. It does not mean we should not take debt we can always think that is it the debt that we can afford? “What if” we are unable to pay it back? What are the protections we have. Definitely one can never be risk free but one can create buffers or make ones system robust.

Like keeping a fund of cash/PPF always for the rainy days. Transfer it from generation to generation. Think of Mr. Warren Buffett his company Geico (an insurance operation) generates a lot of cash, which he deploys.  In one of his shareholder meetings, he clearly explained that Berkshire Hathaway will be there when majority of reinsurance operations (insurers for insurance companies)  fail. Now the probability of  majority of reinsurance operations failing together is minute but they were all near the brink of failure due to an event in past 30 years.

Same happened in 2009 when all banks got scared Berkshire was happy to offer them a deal. Now how could it?

Some things are by nature fragile, while we should strive towards building anti-fragility. (As per Author Nassem Taleb anti fragile things benefit from volatility, randomness). Or we should try to build layers so that no single risk wipes us out completely. Multiple layers of safety will reduce the fragility. If you are running the business in above case one should try to strive towards building multiple layers of safety. Like if your company is dependent on single customer or the customer concentration is too high, one should always try to reduce customer concentration no matter how good the relationship with the customer is.

Take small risk so that no single risk wipes you out completely, if & When  you become lucky in any one situation you can capture the upside (optionality). It does not mean never take risks. Just take prudent risks, allocate capital or resources accordingly. Think you will be unlucky or wrong.

Personally you can build many layers like having super strong relationships with your near dear ones.

The list can go on and on and on…It is important to think about improbable events, then solutions will start flowing. I learnt this the hard way. Wish you all the best in your journey.

  

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