Three Ways To Think About Risk

Introducing Risk

In the finance world, there are many different ways investors can classify risk. There’s credit risk, interest rate risk, inflationary risk, and currency risk. There’s also country and political risk, foreign exchange risk, liquidity risk, and many more types which supposedly make up the entire risk of a security or a portfolio.

But how easy is it to quantify all of these risks and more importantly, are we missing something?

For those old enough to remember, you may recall U.S. Secretary of Defense Donald Rumsfeld talking about risk on the United States’ decision to go into Iraq on the belief of weapons of mass destruction. He talked about three types of risks in this quote from February 12, 2002:

Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.

The phrase “unknown unknowns” has been around since the 1950’s, but Rumsfeld no doubt popularized the saying which is now common in project and risk management circles. And it gives us a different way to think about risk from an investment perspective as well. Simply put, there are risks that we know about and can easily quantify and mitigate (known knowns), risks that we know about but don’t know what the impact will be (known unknowns) and finally, there are risks that we don’t even see coming (unknown unknowns). Rumsfeld posits that this last category is the one we need to worry about the most, and I would agree.

Three Types of Risk

Perhaps you are considering an investment in an electric car company. Or maybe you’d like to get in on Beyond Meat, or are eyeing Impossible Foods for the day they decide to go public. Your logic may be that these products are the way of the future, and that it’s only a matter of time before coal and oil burning is replaced with clean energy and the 9% of carbon emissions from livestock goes to nil. Let’s consider the risks involved in such investments from the Known and Unknown perspective:

Known Knowns

These are the easiest types of risk to quantify. Investment bankers, and investors alike, will look at a company’s balance sheet and earnings potential and assign a price multiple to the company. Various simulations would be run, adjustments would be made for consumers’ sensitivity to price changes (i.e. elasticity of demand), and you could come up with a reasonable estimate of a fair price. Fundamental investors do this all the time - we’re trying to assess the risk in terms of if sales growth will keep accelerating, if companies are able to meet debt covenants, and if companies are able to take advantage of economies of scale. Sure, it’s not a perfect science, but we have the information at our fingertips and can at least plan for various outcomes. These are the “known knowns” we must be skilled at dealing with.

Unknown Knowns

These are risks that we know exist, but don’t know how to quantify and are therefore more of a concern to investors. Using the Beyond Meat example, the company understands that to scale, they need to have a big presence in China and to fail in that plan will put a major lid on its share price. Management are most certainly aware of these risks, but how well can they quantify them? For example:

• Will Chinese citizens embrace the American company, especially during/after such a bitter trade war?

• A much greater cultural emphasis is placed on food in China versus the Western countries. In China, animals have significance at the table so how will citizens react to plant-based, lab-created meat substitutes?

• What lengths will the Chinese government go to protect local meat-substitute companies?

These are questions we can easily think of, but don’t really know the answer to so it’s tough to quantify them and account for them in standard financial models. These are the “known unknowns”.

Unknown Unknowns

Unknown unknowns, as Donald Rumsfeld said, tend to be the difficult ones. Coming up with examples is difficult and requires you to be creative and seek out the opinions of others, especially those not in your field of work. For example, in 2005, no one could have anticipated the impact of Hurricane Katrina. The same goes for the Deepwater Horizon oil spill in 2010, or the Fukushima nuclear accident in 2011. We can go further back in history in the early 1960’s when no one was even dreaming about going to the moon, let alone understand the impact Apollo 11 would have on U.S. history. These “unknown unknowns” come out of left field and can impact the world, and our investments, in both positive and negative ways.

Let’s now return to our electric car investment example. Imagine the possibility that right now, there is someone we have never heard of working on a carbon sequestration solution. It’s scalable, cost-efficient, and has the backing of some of the top world-leading scientists. Governments begin racing to get involved and before you know it, electric car stocks drop because nobody is willing to pay a premium for them anymore because cheaper alternatives exist and the world now has a solution to our climate crisis.

Or what if governments around the world just decide that it’s too late to do anything about the climate crisis, so we might as well live prosperously while we can. Would demand for electric vehicles dry up due to lack of hope, or would the manufacturers still keep pressing forward so they can at least compete on price as opposed to ideology?

What You Can Do

As alluded to earlier, I believe the best way to mitigate known unknowns and even unknown unknowns is to discuss them with as many different people as you can. Seek out differing opinions. Don’t read just one financial blog, but read many. If you’re wondering whether to invest in a company and are relying on the ten analysts who gave it a buy recommendation, the 11th one probably isn’t going to add much value. Talk to your neighbour the welder, your friend the lawyer, and your Canada Post letter carrier. These people are going to have different views on the subject and can help knock you out of any tunnel vision you’re experiencing and help you see risks you’ve never considered before.

My favourite source of information is my wife, who has no involvement in the finance industry. A couple of years ago I had dedicated a much larger portion of my portfolio to Winpak, a packaging and containers company, compared to what I have today. Her reasoning was so logical, but I was so buried in the numbers I couldn’t see it. With the way the world is heading, there will be less demand for packaging. Already I can see it when I head into Bulk Barn and they let me bring my own reusable container. I’ve heard of grocery stores beginning to allow it as well once they get rid of any food contamination concerns they have now. Right now these companies serve a big purpose, but will they in the future?

Besides, as I wrote in my article titled Gender Investing back in August, 2019, my male readers would be well-advised to having a female involved in financial decisions as studies consistently show that this type of arrangement is less risky and results in higher returns. Give it a shot, your portfolio will thank you!

Happy Investing.