A critical lesson about a certain kind of risk that investors often ignore is found in this heartbreaking story about about a cat. A lesson that really applies to the market evironment we have today. 

Eric J. Fry specialized in long/short equity strategies during a 20 year Wall street career. This really enjoyable and valuable read was developed from unique insights on the societal and economic influences that create opportunity… or risk. – Editor Money Talks

In life, there are things, and there are treasures… Things are common. Treasures are rare. 

Not long ago, I lost one of my treasures – a cat named Uzi. Her death reminded me just how devastating a certain kind of risk can be. The risk I’m talking about is called “asymmetric risk”… and it is one that investors often ignore or underestimate.

Asymmetric risks often seem highly unlikely, which makes them easy to ignore. But as Uzi’s heartbreaking story shows, an “unlikely” risk is not the same thing as a “manageable” risk.

Uzi was “just a cat.” I know that. But that fact did not make her any less of a treasure. She was precious to me… which is why I spent hundreds of hours during her brief lifetime trying to keep her alive.

I live next to an open hillside that is home to a variety of wildlife, notably coyotes. But this same hillside is also home to rabbits, mice, lizards, birds and numerous other varmints that excite the predatory instincts of a small feline. So it was next-to-impossible to keep Uzi off that hillside. She would hunt up there almost every day… And almost every day, she would return to the house with some sort of mauled “trophy.”

As long as Uzi conducted her hunting forays during daylight hours, the risks were very small that the hunter would become the hunted. But as soon as the sun dipped below the horizon, the balance of risk would shift dramatically against Uzi.

At nightfall, nocturnal predators like coyotes and owls make the rules for small felines. The problem was, at nightfall, felines still make the rules for mice. And so Uzi was never keen to abandon the thrill of the hunt to return to the relative ennui of watching prime-time television from my couch.

Given the chance, she would roam the hillside at night. But she was rarely given the chance. I was obsessive about keeping her indoors at night. In fact, I was obsessive about locking her indoors well before sunset.

On those rare occasions when she remained outside after sunset, I would scour the hillside until I found her. Sometimes the search lasted a few minutes; sometimes a few hours. But I would continue the search until I found her. Only twice during her two-year life did I fail to find her. Once, she spent the entire night outside. Once she returned about 1:00 in the morning with a mouse in her mouth.

On both occasions, I feared the worst. I assumed a coyote had found her before she found her way back to the house. Then one night, the worst came to pass. I searched for Uzi off and on from 5:00 p.m. until 2:00 a.m. Fifteen minutes after I walked back into the house the last time, I heard the chilling yelps of coyotes that had just captured prey.

Their prey was my cat.

I was heartbroken… and still am. But as I mentioned at the outset, this little story is not merely about Uzi and me; it is a universal story about asymmetric risk.

Investors take note… 

An asymmetric risk has nothing to do with the odds of a given risk, but everything to do with the consequences of a given risk. In Uzi’s case, the odds that a coyote would kill her were relatively low, even on a hillside frequented by coyotes. In fact, the numerical odds were hugely in her favor. She spent more than 50 evenings on that hillside before finally encountering a fatal evening.

So let’s say the odds were 50-to-1 in her favor. But the consequences of that risk were massively asymmetric. In our hypothetical 50-to-1 risk, Uzi returns to the house alive 49 times out of 50. But one time in 50, coyotes kill her. By the numbers, that’s a good risk. In reality, that’s a horrible risk.

No investor would take a bet like that… at least not knowingly.

But investors take asymmetric bets every day. For example, they’ll buy the low-yielding long-term bonds of a heavily indebted nation… or they’ll hold 100% of their net worth in a single currency issued by a heavily indebted nation… or do both of these things at once!

Asymmetric risks can succeed for long periods of time… and that’s exactly why they can seem harmless or irrelevant. But when asymmetric risks fail, they usually fail catastrophically. That’s not a smart risk.

Understanding your potential reward is worthwhile. Understanding your potential risk is everything.

Good investing,

Eric Fry
for The Daily Grind