What is Risk Anyway?

A primer on the different types of risk and how they apply to your portfolio

“Things that have never happened before happen all the time.”

Morgan Housel

So you’ve decided that you have balls of steel. You say “Dolf, you’re talking about 30% corrections? Psssshhhh, I can handle a 90% correction or even bankruptcy at this age! What’s the smartest way I can take on a shit ton of risk?” If you ask, I shall answer.

Before going into how to allocate an extremely risk seeking portfolio, it’s important to talk a little about what risk is first. There are two different kinds of risk: systematic risk, and systemic risk. Systematic risk is market risk, one of the types of risk we can’t diversify away from. The type of risk can diversify away from is idiosyncratic risk. This is the risk that Elon Musk will tweet saying he’s taking his company private, or the risk that a Facebook intern accidentally crashes the Metaverse servers for a day. We can diversify away from this type of risk by buying different assets.

Systemic risk is the type of risk that will kick your balls of steel to see if they’re truly made of iron. Systemic risk is the risk of the entire system collapsing, regardless of what happens to the individual parts. This is the type of risk that will make returns negative over a 30 year period. If there’s a pandemic that’s as lethal as Ebola and as contagious as the coronavirus, it won’t matter that Zoom has the first mover advantage on work from home technology, the marketplace is collapsing so it really won’t matter.

Everything I’ve said above is pretty straight forward, but here’s where people start to make big mistakes with their portfolios. Diversifying within the same asset class will merely spread-out systemic risk, not eliminate it. The only way to reduce systemic risk is to have a certain percentage of your portfolio in super safe assets, like cash, T-Bills, etc. At a low level, this makes sense to most people. You can’t diversify away the risk of the Brazilian economy by buying more Brazilian stocks. Here’s where people make the mistake: you can’t diversify away the risk of the entire stock market by buying different sectors of the market.

The way to allocate your assets correctly once you understand this is to use a variation of the barbell strategy, courtesy of Nassim Taleb. He argues that it’s pointless to diversify among different sectors or stocks within the asset class. Instead, you should pick one asset that suits your risk level, and vary your cash percentage. Riskier portfolios will have less of the risk free asset, and more of the riskier asset. I break down an example below:

As you can see, to get the desired level of risk we want, we can just vary the percentage of our portfolio in cash to get the desired level of risk. If you wanted to increase the risk of this portfolio beyond 20% per year, we would switch out US Small Cap with an asset that has a greater risk profile.

Taleb’s favorite strategy is to put 10% of his portfolio into far out of the money LEAPS, and 90% of his portfolio in cash. You can read more about his barbell strategy in the book The Black Swan, but there is evidence that his version of the barbell strategy outperforms the S&P 500 over the long run.

When determining what level of risk to take on, it’s important to think about the risk of bankruptcy. If you allocate too much of your portfolio into risky assets, there’s a higher likelihood that your portfolio will collapse faster than you can replenish the losses to make you whole. Even if we have an extremely strong appetite for risk, we still want to avoid financial ruin at all times.

Even if you have balls of steel, make sure you don’t blow up your portfolio!

Convinced you can beat the market? Be sure to check out my last post “Can You Throw Darts at a Wall Better Than a Monkey?”