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Daily Speculations The Web Site of Victor Niederhoffer & Laurel Kenner Dedicated to the scientific method, free markets, deflating ballyhoo, creating value, and laughter; a forum for us to use our meager abilities to make the world of specinvestments a better place. |
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4/13/2004
Department of Strategy:
Tom Ryan on Resilience
In my experience conditioning with small shocks to improve resilience has had both positive and negative effects. Positive in the sense that it can provide a real live-fire experience of what "cost" can mean in the "cost-benefit" analysis, which is helpful for understanding one's risk acceptance. I recall one particular meeting back in the 1980s with the upper management of a large mining concern where at the end of my presentation I was asked by the CEO, "Just to clarify, you say your best estimate is a 10% chance of this happening?" Yes.. "Well hell, forget about all of those cost benefit numbers. I'm bettin' on the 90%". I mumble something about Princeton, prospect theory. And after the CEO leaves the hired help turns to me and says, "Don't worry about him -- he's just the CEO." (A few years later when the 10% did come into play, there was a new CEO, but that is another story for another post.)
In any case conditioning does help build confidence to deal with routine losses, but I have also found that it has the negative consequence of building up unrealistic expectations, in the sense that we have often seen that too many 0.5 std deviation events in a row lend people to be unprepared, psychologically, and financially, for the 1.5 std deviation event. Which recalls an experience last fall with a client who told me upon my arrival, "We expected a slide of rock, but not THAT BIG of a slide of rock".
As Mr E has said many times, show him a low volatility 30% return on equity and he'll show you a chaos put in the making. In physics, resilience is defined as a value that characterizes a material's resistance to shock. Subsequently it was adopted by ecologists, initially in the same sense as in physics to express the idea of a system's stability around a point of equilibrium. Thus, applied to ecosystems, resilience defines the capacity to resist a large unexpected perturbation and the ability to return to an equilibrium after having been subjected to a shock.
In 1973, Holling proposed a new significance for the term. Holling's new definition was no longer based on the traditional homeostatic systems approach (emphasis added by me) "Resilience is the capacity of a system to absorb and utilize or EVEN BENEFIT from perturbations and changes that attain it, and so to persist without a qualitative change in the system's structure." To me the key here is not simply survival, but to benefit from the shock or event. I like his definition because Holling distinguishes very clearly between stability and resilience; the first indicating a system's capacity to return to equilibrium, and the second the fact that the system does not lose its internal structure in a period of perturbation. A system can be highly resilient and yet fluctuate widely, i.e., have high resilience but low stability (trading systems come to mind). A resilient system is able to incorporate changes in its way of functioning without changing qualitatively.
Another essential distinction between this perspective and the homeostatic systems approach concerns the way in which uncertainties and risks are taken into account in a system. Traditionally, human societies have searched for means to reduce uncertainties and risks by increasing their control over their physical environment. For example, we generally choose to protect ourselves from natural environmental hazards (for example by constructing dikes against flooding), and we justify large expenditures of this nature with reference to medium-term risks defined by the historical data. Meanwhile we prefer to consider the occurrence of long-term events (events with return periods longer than our lifespans) as uncertainties which are too difficult to take into account.
Risk management professionals have preferred to ignore such long-term uncertainties, because they are in-precise, and to turn their attention instead to the risks that occur frequently and that can be readily calculated (VAR). In regard to resilience, the types of risk we are concerned with all tend to have a low probability of occurrence, placing them into the realm of low-probability but high-consequence risks. We know from experience that low-probability-high-consequence risks are very, very difficult to manage. Thus there are two closely related aspects of resilience which must be considered. The first concerns the behavior of a system, due to the structure of its attributes and the interactions between them, the other aspect concerns how one formulates models of unexpected or even unforeseeable future events. One must have not only a mechanical resilience, but a mental one as well. The four conventional risk management strategies in finance are:
All of these strategies can be used to promote resilience but the effectiveness of each strategy is highly dependent upon the nature of what is being protected and the type of system disturbance. Coming back full circle, mentally, it would seem to me that there are similar personal strategies that we can employ to improve our personal resilience beyond conditioning. I can diversify my personal interests a bit, so in the hypothetical case of losing my business, I would still have plenty to live for, my trading, my family, my non-profit work, my friends, the spec list etc. I can also insure myself by building close relationships with friends who would be there to help me psychologically in case I get knocked down by a catastrophe of some sort. I can also hedge my financial life with my spiritual pursuits of my personal god, and thru constant education and knowledge building I can make sure that I have a reserve of intellectual capital and mental strength to fall back upon in case my life burns down - I can build up a new one because "I know how."