Today I’m discussing risk.
Specifically, a type of risk known as “tail risk.”
As Morgan Housel puts it, it’s the hardest for people to understand…
…and it’s the only one that really matters.
If you want to learn what tail risk is, why it’s important, and how to mitigate it, today’s episode is for you.
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- Morgan Housel:
- The Three Sides of Risk
- Psychology of Money
- Tails, You Win
- Morgan Housel on Retirement Investing and Psychology [Stay Wealthy Interview]
- The Biggest Risk is Trying to Eliminate Every Risk
- What is Tail Risk
The Biggest Risk
Taylor Schulte: I’ve been on skis since I was two years old.
And in my teens, my dad and I started taking annual ski trips together.
We’ve missed a year here and there, but it’s still very much a tradition that’s alive and well.
In fact, I just returned from our recent trip to Sun Valley, Idaho. Side note, if you’ve never been to Sun Valley, I highly recommend it. The food, the people, the landscape, the history, the airport tucked between the mountain ranges, it’s a special place.
Anyhow, a few years ago, Morgan Housel wrote an article titled “The Three Sides of Risk.” And since then, I think of it (and re-read it) every time I’m in the mountains.
This year was no different. In fact, I had my dad read it as well.
In the article, Morgan shares a personal (and tragic) story about what skiing taught him about investing.
Welcome to the Stay Wealthy Podcast, I’m your host Taylor Schulte, and today I’m going to share Morgan’s story and use it as a launchpad for talking about one of the most challenging forms of risk to comprehend.
To grab the links and resources from today’s episode, just head over to youstaywealthy.com/182.
Morgan Housel grew up ski racing. And, as told in his article titled the three sides of risk, one day back in February of 2001, after a couple of big storms hit Squaw Valley in Tahoe, he and two of his closest friends, decided to head out-of-bounds and ski the backside of the mountain.
Fresh, untouched snow, no rules, and challenging terrain, it’s what every experienced skier is after
Their first attempt was a success, minus a small knee-high avalanche that added to the excitement.
When they safely get to the bottom and catch a ride back to civilization, Morgan’s two friends, Brendan and Bryan, wanted to go back for round two.
Morgan, for an unknown reason, opted out of the second run but offered to pick them up in his truck at the bottom of the out-of-bounds area so they didn’t have to hitch a ride back.
They solidified their plan and split ways.
As discussed, Morgan went to the pick up spot at the agreed upon time, but his two friends never showed.
The unimaginable had happened.
Search and rescue teams eventually found Brendan and Bryan sometime after midnight buried under 6 feet of snow. Their lives had been cut way too short at 17 years old.
The entire article is worth reading (and re-reading), and I’ll be sure to link to it in the show notes.
So what does this story have to do with investing?
As Morgan put it, this tragic event that happened more than 20 years ago opened his eyes to the idea that there are three distinct sides of risk:
The odds you will get hit.
The average consequences of getting hit.
The tail-end consequences of getting hit.
“Getting hit” is just a metaphor for an event occurring, either positive or negative.
Most can grasp the first two (the odds of something happening and the average consequence of that thing happening) – but the third one, he argues, can likely only be learned through experience.
The third side of risk is commonly referred to as “tail risk.”
In the investing world, the definition of tail risk is “the probability that an asset performs far below or far above its average past performance.”
In other words, a tail risk event is an extreme event (positive or negative) that has a very small probability of occurring.
As you would expect, most people are concerned about negative tail risk events. Or, I should say, most are concerned about them once they understand them and their consequences.
Morgan and his friends knew that skiing – especially skiing out of bounds – involved risks.
They also knew that, with their level of experience, the average consequences of skiing out of bounds were tolerable and survivable.
What they didn’t fully grasp were the tail-end consequences of skiing out of bounds. More specifically, the negative tail-end consequences. And those low-probability, high-impact events are all that really matter.
Here’s what Morgan had to say.
“My risk tolerance plunged after Brendan and Bryan died. I broke my back skiing a few months later, which crushed my tolerance for risk even more. I haven’t skied much since. Maybe ten times in the last 15 years. If I’m honest, it scares me.
I’ve been risk-averse in other areas of life ever since, too. I drive the speed limit. I obey the seatbelt sign on airplanes. I invest in index funds.”
As Michael Batnick once put it,
“the biggest risk investors face is trying to eliminate every risk.
How do I hedge against inflation?
How do I limit volatility?
How do I avoid drawdowns?
Instead of trying to eliminate everything that can go wrong, the best investors find their sweet spot and let time do the rest.”
So, how can we best hedge against tail risk?
First, it’s important to understand how tail-end consequences might impact you and your retirement plan. As Morgan noted, it’s often hard to grasp the concept and, in many cases, unfortunately, you just have to experience it.
Perhaps you already have. Perhaps the unimaginable happened in 08/09 and not only did you lose your job but you lost 60% of your retirement savings. Or you got caught up in the dotcom bubble, lost everything, and had to start over. Those challenging experiences might have helped to reshape your investment philosophy and approach to taking risks.
Regardless, going through a comprehensive planning process and shocking your plan for low-probability high-impact events can potentially help bring tail-risk events to the surface and help highlight opportunities to mitigate them.
As I’ve said many times here on the show, knowledge is power, and knowing what could potentially destroy your financial plan can help you make more informed decisions with your money.
The next hedge is time. As you extend your investing time horizon, you reduce the chances of a tail risk event crushing your plan. Long-term investors will always have a better and more positive investing experience than short-term investors.
Lastly, since time isn’t on everyone’s side, the final hedge against tail risk – both positive and negative – is diversification.
Let me first address why diversification allows us to benefit from tail events with positive outcomes.
In 2017, the S&P 500 rose 22%. Twenty-three companies out of all 500 contributed to half of that return. Apple stock alone contributed to more of the return that year than the bottom 321 companies combined.
In 2021, the Nasdaq was up 32%. Twenty-five companies out of 100 accounted for 75% of that total return.
According to JP Morgan, from 1980 to 2014, 40% of all the companies in the Russell 3000 index lost at least 70% of their value and never recovered.
If you were a stock picker, odds are slim that you would know what stocks to own and what stocks to avoid every single year.
By diversifying your investments and choosing to own the entire global market through low-cost index funds, you are a direct beneficiary of tail events with positive outcomes.
Diversification, of course, also helps mitigate catastrophic losses from tail risk events. In addition to having a properly diversified portfolio, it’s wise to also have an emergency fund, an additional war chest of cash and bonds if you’re retired, and the right types of insurance. It would also be prudent to rebalance your investments, pay off debt, live below your means, and regularly review and update important documents like your will, trust, power of attorney, and advanced medical directive.
The combination of all these smart, diversifying decisions coupled with time and a clear understanding of how tail risk events might impact you, dramatically reduces the chances that a low-probability, high-impact event puts your plan in jeopardy.
As Morgan Housel wisely concluded in his article,
“In investing, the average consequences of risk make up most of the daily news headlines. We spent the last decade debating whether economic risk meant the Federal Reserve set interest rates at 0.25% or 0.5% and 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.”
Once again, to grab the links and resources mentioned in today’s episode, just head over to youstaywealthy.com/182.
Thank you, as always, for listening and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.