True Risk and False Risk by Qiu Guolu

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Originally written in Chinese by Qiu Guolu
Translated by Yi Liu

I. Perceived vs. Real Risk

There are two kinds of risk, one is perceived risk, the other is real risk.

After a stock skyrocketed, the real risk rose, but perceived risk fell. When $SSEC (Shanghai Index) reach 6000 in 2007, stock market’s most dangerous time, everybody felt like to sing and dance to celebrate the good times. After the stock market plummeted, the real risk fell, the perceived risk rose. But when the stock market reach relative low of 2000 point in 2008, people were feeling like a bleak storm.

To travel the same distance, death rate by car is more than 60 times higher than by plane. But there are many people who have flight phobia yet few who are afraid of travelling by car.

Perceived risk is big by plane, but real risk is small (the probability of an accident is only 1/6,000,000). So selling air insurance is a good business.

II. Exposed risk and hidden risk.

From another perspective, risk can be divided into exposed risk and hidden risk.

We should take exposed risk, because people have avoided the stock liked the plague, risk has been reflected in the price. Taking such risks will have a corresponding high return.

Instead, we must avoid hidden risks, because people are not aware of their existence, and there is no corresponding reward for taking such risks.

After 9/11 attacks, people dared not fly. However, for September 12th, compared with September 10th, the exposed risk is greater, but the hidden risk is smaller — the next decade is the safest in American aviation history.

In the months after 9/11, many people drove instead of flying, killing 1500 more people in highway crashes than usual.

The ability to distinguish between true and false risks often reflects the culture and capacity of a financial institution.

In October 1987, when the U. S. stock market collapsed 23% on Black Monday, Goldman Sachs’ risk arbitrage trading unit lost a lot, Robert Rubin smiled and said to the team, “the company has confidence in you. If you want to increase your position, go ahead and just do it.”

In sharp contrast, rival Smith Barney laid off all employees in the arbitrage division after Black Monday.

In fact, after Black Monday, exposed risk is very high, but hidden risk is low; perceived risk is high, but real risk is low.

The ability to distinguish and take advantage of the differences between the two kinds of risk is a necessary condition for successful investment.

III. Risk of price volatility and risk of permanent loss of capital.

In another perspective, risk can also be divided into the risk of price volatility and the risk of permanent loss of capital.

When the market is above 5000 points, the stock price is rising day by day, water is calm, risk of price volatility seems small, but the risk of permanent loss of capital is huge.

When the market was at 2000 points, share prices were falling, choppy, and the risk of price volatility seemed great, but the risk of permanent loss of capital had shrunk dramatically.

In the United States, the $VIX index measures market volatility. And each time the bottom of the market is accompanied by a high point of VIX, that is, when the market is most volatile.

Why do people often cut positions at the bottom?
It is because the market bottom is often also the most volatile time, and most investors are very weak to bear the risk of stock price volatility.
And they often confuse the risk of volatility at the bottom of the market with the risk of permanent loss of capital.

There was a story about a lovelorn man who found an old monk. He said, “master, I can’t put this off.” The old monk asked him to hold a tea-cup and pour into it hot water. The water eoverflowed and burned his hands. Then he put the cup down. Said the old monk, Your thing is the same as the cup of tea — burnt, then you will put it off.

Many people trade stock in the same way: price goes up, nice, then full position; price falls, pain, clear all the position. This is how low position at bottom and high position at peak come from.

In fact, for contrarian investors, the most painful time, is often the last time to let go.

As Soros put it, if you can’t afford to lose, don’t get into the market, because no one can win every game.

However, for professional investors who manage other people’s assets, the risk of market volatility is real risk. And in the event of client redemption or risk control forced stop-loss, it will be converted into the risk of permanent loss of capital.

So, for every fund manager, the prerequisite for success is to manage products that suits one’s investment style and to find a client base that suits one’s investment style.

IV. True vs. False Risks.

People often say, high risk, high return; low risk and low return.

In fact, risks and returns are often not proportional. It is indeed impossible not to take risk when investing.

However, successful investment is to take those risks that have been exposed, felt by everyone, with corresponding discount but very little real danger — those “false” risk.