Risk and Return

I had failed stuff before, but not academic stuff. When I got to University, I was left dazed and confused on several occasions. Sometimes for time pressure reasons and the sheer volume of work to get through. I was made to fully realise the limits of my academic ability. My mantra getting through was, “This is not Rocket Science. You are not pushing the boundaries of human thought. Other people have done this before.” One idea that I found really problematic coming out of the maths of finance was the oversimplifying of risk to volatility. Volatility is quantifiable. It is how much the average observation, differs from the average of the observations. So, if you know the average, how far “on average” will one of the parts be away from that. It is appealing if you can count something. If you want to believe in a world where you can clearly say return simplifies down to a number, and risk simplifies to a number. Then you can adjust return for risk. Take the level of risk appropriate for your appetite, and you choose the option at that level with the highest reward. Now, that seems beautifully simple. It is just wrong. You don’t get paid for taking risk. You get paid for value added. You don’t get paid for complexity, you get paid for solving things. You don’t get paid for not failing. You get paid for getting to a solution.

 

Space and Time

Be super careful what you count. Not everything can be reduced to numbers. It is essential to be able to jump to an alternative reality free from the constraints of space and time. A reality that is still. Where you can breathe. Financial Mathematics is built around reducing decisions to Risk and Return. Around concepts like Time Value of Money and Opportunity Cost. “Net Present Value” is meant to be a framework for decision making. You set up the inflows and outflows into the future and discount them back at a required rate of return. Then you choose. The fundamental flaw in all of this is that neither Risk nor Return can be reduced to numbers. We see what we want to see, and models will show us whatever we most want to see. The world is complex, ambiguous, and random. By the time the numbers are out, it will be too late. Even then, there is so much noise our choices still boil down to judgment calls. Numbers give the illusion of control. Confidence gives the illusion of understanding. No one can, or does, know. What we can do, is build the ability to cope. We can value every moment without discounting it, and connect what comes before to what comes next. Not making anything so important that we lose everything. Making space and time.

What Reality Counts

Not everything that counts can be counted. Investment is not a game you play where Risk and Return are knowable and the only two items on the scoreboard. What you do genuinely matters. Fundamentally. It’s not a game. My biggest quibble with wealth creation is the illusion of control and associated arrogance that can arise in people who have “done well”. Like the TV series Westworld where the penny drops about “what are we actually doing here?”, it is easy for us to get fooled by randomness. To see patterns we want to see. To get lost in our own illusions. At times of major crisis, you need to look beyond the numbers. What really matters? What is a distraction? What is the core that will allow you to rebuild? What are you building and why? Throw away the stop watch. The time sheets. The productivity measures. Time and opportunity cost lose their power. Repurpose to meet the challenge.

What really matters?

Due Diligence

Once you have bought into the idea of building an Engine, and you have tamed your expenses to the point where you are reasonably in control, the next question is “How?”. Treat your money like you treated your first productive asset (you). Get it some work. Know what that work is. There will be plenty of people trying to convince you they can manage your money. Make sure you do Due Diligence. That means asking good questions, and avoiding people who only promise upside. Be especially careful of the word “Guaranteed” and anyone promising high returns. Sustainable growth is the key. Charts of past performance don’t show the others who tried the same thing, but failed. I am a Soutie. One foot in South Africa & one in the UK. SA is blessed with many great asset managers, and I don’t believe any are touched by the Gods. I invest in Global Equity Funds with the two companies I worked at, and then have an Interactive Brokers account where I have a portfolio of about 20 companies where I have got my money jobs. Don’t invest with anyone just because you think they are smart or cunning. Invest when you understand what work it is your money is doing.

What work is your money doing?

Beyond the Numbers

Money making, once you release the question “what do I want to be?”, boils down to Capital allocation. Where will resources be most effectively put to work? What job will I get my money? Except money doesn’t face the existential questions we do. Where we are judged for our merit as a person by the choices we make, and the things we can do. Where respect and love are conditional. Money just does what it is told. Money makers still have a philosophy. They still face some existential questions about how to allocate Capital. Evidence mounts over time as to whether it has been well allocated, but there is a lot of noise. The holy grail is sustainable growth. Compounding over a long period of time. That requires looking beyond the numbers. At what could of happened, but didn’t. At things that have never happened before, but would be a big deal if they did. At what does happen at the core, but gets missed because we focus on the frills and glitter. Done well, Capital allocation leading to sustainable growth can free people from filtering the question “what do I want to be” through filters like “how can I make money out of this?”.

Filtering for Money