Moderated by: Sunil Singhania, CFA, Founder – Abakkus Asset Manager LLP
Contributed by: Siddharth Gupta, CFA
The 10th India Investment Conference opened with a session by Allison Schrager, titled “Unexpected places to understand risk”. Allison Schrager is an Economist and Journalist, writing for Quartz, and author of “An Economist Walks into a Brothel”. The session was moderated by Mr. Sunil Singhania, CFA, founder of Abakkus Asset Manager LLP.
Allison’s talk was stimulating, and gave a differentiated look at Risks faced and the ways they’re mitigated by people outside the financial world. Freakonomics for finance would be an appropriate analogy of Allison’s talk, with seemingly unrelated examples from the real world revealing wisdom pertinent for finance professionals.
Allison highlighted issues faced in retirement finance due to lower ‘risk-free’ rates, which is akin to paying a lot for low risk, and how that is pushing portfolios towards riskier assets in order to generate portfolio returns.
For the first unexpected place to understand risk, Allison spoke of the case of brothels. While the business isn’t legal in most states in the USA, Nevada is one of the states where it is legal, albeit with heavy regulation. The setup she first visited in Nevada had each worker negotiating the rate with each customer individually. The brothel in fact gave special negotiation training to its workers, which Allison attended. There were some interesting takeaways, such as the average brothel worker charging $1000 per hour, vs the national average of $300, with one of the top employees making a million dollars last year!
The key takeaway, was that 50% of the earnings went to the brothel administration, for carrying out a licensed, regulated set-up. Allison highlighted how the workers were willing to pay up such a high share, despite having the option of running their own unregulated set-up, purely because the set-up was regulated and was considered safer. Customers also preferred the organised set-up, as it minimised risks and hassles for them, despite having to pay ~3x the National average amount charged. These financial trade-off decisions were being made by customers and brothel workers every day, prioritising risk minimisation over high cost, and this was akin to the current environment of lower risk free rates.
For the next example, Allison moved into the world of celebrity photographers, the Paparazzi. One of the key characteristics of this market was the fat tail upside, with photographers having to get lucky to get a photograph that could bag big bucks. The average photographs tend to be commoditized, paying very low dollars per photo. To eliminate this idiosyncratic risk, the market started seeing alliances of photographers, with an understanding to share incomes, tips, strategies, etc. However, these alliances / partnerships were often unstable, as they weren’t enforceable by law. Nonetheless, this market-driven mechanism to bring down idiosyncratic risk couldn’t save them from the systemic risk being faced by the industry in the wake of the Global Financial Crisis (GFC). Post-GFC, the agencies through which photographers sold photos to magazines, witnessed consolidation. This consolidation changed the market structure, where instead of selling photos individually, agencies started having subscription contracts with magazines and glossies, and this reduced payouts for photographers in general. This was aggravated by the rise of social media applications, which saw celebrities engaging with their audience directly, and in turn, taking away potential earnings from photographers.
For the last example, Allison turned to the world of surfboarding, and had two takeaways. She recounted an interview with a surfer who almost lost his life. When the surfer fell off a wave and was pushed into the insides of the sea, he had two choices: to stay in the calm insides and wait it out, holding on to his breath (surfers are trained for it), or to try pushing up and risk being pushed down again by another wave. He instinctively swam up, but was unfortunately pushed down. Fortunately though, a jet ski nearby saw this, and rescued him. On further interrogation with other surfers, Allison discovered the following fact: Waves travel in sets of 5, and it’s convention to not surf the first two of a set, precisely to help in cases where the surfer loses control and is pushed down. In this case however, the surfer took on the first wave. On asking the surfer why, his response was interesting: the previous sets had less stronger 4th and 5th waves, where he couldn’t surf properly, and he was getting restless as the day was nearing an end. This made him take the riskier decision of going for the first wave of a set. Allison highlighted that it’s similar to how lower risk free rates are pushing portfolios towards riskier terrain.
What piqued her interest in the world of surfing, however, was the use of jet skis. Initially introduced as insurance, where a common jet ski was used to save surfers from drowning, it’s use was fast changing. Surfers started taking on greater risks, pushing towards more difficult waves, with the knowledge that jet skis were around (in fact even using them to be pushed onto the higher waves). This was akin to financial derivatives, which were introduced as a hedging mechanism, but are used in today’s world to make leveraged bets. The person who introduced these jet skis to the surfing arena, was in fact proud of how jet skis have improved overall safety levels, and brought on more avenues to the sport. Allison highlighted that just as how financial innovation such as derivatives often get blamed for creating instability, they are behind a lot of success of financial markets as a whole, and achievement of objectives such as poverty alleviation, economic growth, etc.
After her chat, she was probed with some very interesting questions by Mr. Sunil Singhania, around the examples cited in her presentation and more.
Some key takeaways from the QnA session:
- There’s often too high a focus on the fat upper tail, even when the probabilities are very low.
- Clear and honest communication with clients is important, and it’s essential that the client understands the risks involved in the investment operations.
- Risk is just an estimate / probability distribution of what could happen, but uncertainty is where you have no clue of what could happen. To understand risk, one needs to model it and take effective hedges. The only insurance against uncertainty is Liquidity.