Opportunity Risk

If you don’t want to read about September 11, I suggest you skip ahead to the alternative introduction.  My brother’s Facebook post today, that he’s glad I wasn’t hurt in the attacks, got me thinking about how different things would have been for my family had I died that day.  My first thought was that my youngest child would not have been born and I was deeply saddened that we (or rather they) would have never gotten to know that wonderful person (after I did the math, it turns out she had already been conceived but I ran with the notion that she had not, just to see where it took me).  In this case, the risk was not of losing something valuable (the father), but rather the risk of never getting something good (the future child). We don’t usually think of risk this way – risk is almost always cast as the risk of losing something you already have.  It’s not cast as a chance of not getting something beneficial that you don’t yet have.

Alternative introduction: One of the most amazing things I was taught by a college physics professor was to think of time flowing “backwards.”  When I first heard of this, it was just bizarre to me.  But she was persistent: “nothing in the equation forces time to flow in a particular direction, so it may help your understanding, if you think of time flowing backwards,” she told me.  When I entered financial services several years later, that’s exactly what helped me understand short selling.  Instead of buying low and selling high, a short seller is first selling high and then at a later time buying low. Conceptually, it’s no different than traditional investing except with the arrow of time flowing in the opposite direction (of course, in practice, it’s very different because of borrowing requirements and other realities).  I decided to apply this “time reversal” concept to risk management: instead of thinking about risk as the risk of losing something you have (today), why not think about a different kind of risk: the risk of not getting something you want in the future.  We don’t usually think of risk this way – risk is almost always cast as the risk of losing something you already have.  It’s not cast as a chance of not getting something beneficial that you don’t yet have.

Are they really the same thing?  I mean, should we consider the risk of not achieving a goal, or of not realizing a financial gain on equal footing as the risk of losing something we already have?  Behavioral economists tell us that we feel about twice as much “pain” when we lose something as the amount of “pleasure” we feel when we get that same thing.  So we don’t treat them equally – losing what we already have is viewed by us as twice as bad.  When examined through the lens of evolution, there’s a reasonable explanation for this otherwise strange phenomenon – in a resource scarce environment, like the African Savannah we came from, survival depends more heavily on retaining the resources you already have than on getting new ones.  But that’s not the world we live in today – today’s resource rich environment in which people can swap one resource for another very easily (using money), we should reasonable consider a loss of something to be just as bad as it is good to get that same thing.

So, it seems reasonable to me that financial risk management, which concentrates on the risk of losing value and ignores the risk of not making value, is looking at only half the risk.  It’s like not taking advantage of short selling.

Now the really hard question is how do you try to quantify the myriad possibilities of what might become or what might have been?  One way, it seems to me, is to look at the trades that were actually made and consider what the portfolio would have done had those trades not been made.  But this is not the whole game, because had those trades not been made surely some other trades would have been made, but which ones?  If a manager keeps a list of “suggested trades” or prioritized trades, then maybe a system can track what the portfolio would have done if those other contemplated trades  were made.  Or, perhaps, it’s better to simply compare it to the default assumption that no trade is made.  Either way, at least some consideration is made to the risk of not realizing some gain.

Similar to the notion of “opportunity cost,” it seems reasonable for risk managers to contemplate “opportunity risk.”  I’ve never heard of anyone doing this, and I’d be very interested to hear if anyone has.

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