Double Jeopardy

I love cycling.

I’ve had a bike for as long as I can remember but I took up cycling (as opposed to riding my bike) properly a decade or so ago, doing the 1,000-mile schlep from Lands’ End to John O’Groats in a little under ten days. The trip taught me a lot, mostly that I’m not a very good cyclist. Although I’ve got reasonably long legs, which should help, any advantage is more than overwhelmed by my near 18-stone bulk meaning I am pretty slow most of the time and very slow up hills – on the plus side, I’m a downhill demon. This meant I was never up with the leaders; usually I couldn’t even see them, but at least sticking with the laggards made for a more sociable trip. It also stands out as the furthest I have cycled without falling off, which I seem to do often enough to accept I am less a cyclist, more a fat bloke on a bike.

The last time (perhaps I should say most recent, as I doubt it will be the last) I fell off was on a lovely summer’s day last year. I was on a bucolic Saturday morning loop. It was so wonderful, so perfect, that I thought I’d add ten miles by exploring some new lanes. Approaching a shallow ford, I sped up to whizz through, hit the water, the bike flipped from under me on the slippery layer of algae that coated the floor and I bounced along the newly graveled road. Flaying as a punishment died out with the Ottoman empire but it is being revived as an alternative to self-flagellation by middle-aged men in lycra who, like me, throw themselves at speed along metaled surfaces at depressingly regular intervals. I knew my tumble hadn’t caused any real harm but losing the top layer of skin from one side of your body is blimmin’ sore. The lane was quiet; I decided there was no great rush to get up, so I lay there for a bit.

All life is a risk, but I’ve always struggled with the concept of risk, especially as it is presented in financial services. People are assumed to have a consistent ‘attitude to risk’; often expressed as a single number. This just doesn’t sit comfortably with my own thoughts or my experience of advising people over the last 30 years. Attitudes to risk are context dependent. Someone can have a range of attitudes to risk depending on what you might term jeopardy where risk is the chance of something happening and jeopardy captures the harm that will be caused if it happens. If I walk along a foot-wide plank the risk of me falling off is the same if it is laid on the ground or suspended twenty feet in the air – in this context, the jeopardy is significantly different.

Establishing someone’s attitude to risk is a key part of our process. My attitude to cycling risk is reasonably straightforward – I don’t want to fall off but if I must I don’t want to do any permanent damage. I suspect that’s pretty close to most people’s attitude to risk for most things. If you ask me to put a percentage on how much harder I’d be happy to hit the ground if it meant I could go a little faster then I suspect I’d struggle and in the end my answer would be much the same, I’d rather not fall off.

Every time I get on my bike there is a risk I’ll hurt myself, so I take reasonable precautions. I didn’t like wearing a helmet; bouncing along an icy road and very nearly head-butting the kerb changed my mind - and probably saved my life a few years later. With investment portfolios we don’t particularly want to hold protective bonds and other defensive assets while shares are soaring, but we are very glad of them when something goes awry. And, like the ford, we can’t always appreciate the risk into which we’re charging.

This month sees the 70th anniversary of the publication of Harry Markowitz’s seminal paper ‘Portfolio Selection’, which introduced the notion of an efficient frontier to portfolio construction. It’s based on the observation that, faced with two portfolios with similar expected returns, a rational investor would plump for the one that exhibited the lower risk.

It’s difficult to overstate the impact of Markowitz’s paper on today’s investment industry, and pretty amazing that Dr Markowitz’s is still alive. It formed the basis of the Capital Asset Pricing Model (CAPM) and led directly to the launching, and ultimately the dominance, of passive investment funds. Our portfolios are built using his principles. Modern day financial alchemy is not about turning base metal into gold but rather about creating efficient portfolios by blending a myriad of non-correlating assets. His ideas mean we look not so much at the performance of a discrete asset but more its influence on a portfolio as a whole; they mean we consider more carefully the trade-off between risk and reward.

While its central tenet has stood the test of time, other aspects of ‘Portfolio Construction’ have come in for criticism. Markowitz uses volatility as a proxy for risk, which has the effect of regarding any given deviation from the average, positive or negative, as an equal risk. In the wider world we tend to think of risk as the chance of a negative outcome – the Cambridge dictionary defines risk as ‘the possibility of something bad happening’ – rather than as Markowitz’s meeting of Triumph and Disaster as equal imposters.

A theme explored in a recent book by John Kay and Mervyn King (Radical Uncertainty) is the interplay between risk and uncertainty. Risk is the possibility that things might go wrong. Uncertainty is not knowing what the future might bring. By mapping historic correlations, it can be argued that, in using this to measure ‘risk’, Markowitz is creating an illusion of certainty in a fundamentally uncertain world. This is not necessarily a bad thing. As humans we need at least the illusion of certainty to make decisions but at some point in the process we need to accept that we are dealing with an unknowable future.

As I lay gathering my breath and wondering which limb to lift first, I heard voices approaching. The thing about falling off your bike is that no matter how much it hurts, the embarrassment hurts more. Ordinarily I’d have leapt up and sat down on the bank, nonchalantly pretending I was simply having a break. ‘What about all that blood?’ ‘Oh, it’s fine, just a scratch’. This time I was too sore to move, and they were too close. I lay back and closed my eyes.

‘Hello Richard’

Rodney is someone I’ve played rugby with for the last twenty-odd years. He was on a ride with a group of friends. Together they scooped me up, gave me an energy drink, wheeled my bent bike to the side of the lane and gave the ever-patient Mrs R directions to collect me.

In an uncertain world, there is always a risk that you will bump into someone you know, even in the most unlikely circumstances – but that’s not always a bad thing!

Richard Ross

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