In life there are obvious risks, such as using power tools without protective equipment or running red lights. There are also subjective risks that depend on your preparation level and area of expertise. The definition and perception of risk can vary drastically from person to person. The question is: how can we help our decision-making when we are confronted with risk, and how do we know if we are properly calculating risk?

Risk is what we don’t see

Risk is not one size fits all. Some of us seek adventure and like to ride down a mountain on a bike or climb up a mountain with only a helmet for protection, while others have their stomachs turn at the very thought of either activity. For these brave mountain bikers and climbers, they will say their risks are calculated. They plan for the risks, take necessary precautions and have practiced on smaller scales before graduating to the bigger mountains. When something goes wrong, it is usually because of something unexpected that wasn’t part of their planning process. Quite often, risk is what we don’t see.

Flying vs. driving

Morgan Housel is a prolific financial writer and a partner at the private equity firm, Collaborative Fund in the U.S. In a presentation in Edmonton a few years ago, he shared a story to challenge the way we thought about risk. Here is a paraphrase of the story he shared:

I want to challenge the way you think about risk. Let’s look at 9/11. September 11, 2001 changed the world as we know it. Close to 3000 people died. It brought the financial system to its knees. It also changed the way people thought about risk and in particular air travel. Following the tragedy of 9/11, air travel sunk for several years. Now here’s where it gets interesting. Simultaneously, as air travel declined Americans spent more and more time driving and this is the result: more Americans died in 2002 trying to avoid terrorist attacks by not flying and instead driving than those that died in the 9/11 attack itself.

One of the greatest “risks” people perceived was the only risk that they could see following the horrific acts of 9/11; air travel was scary. However, another risk was present in the unseen/un-thought-of risks associated with driving in a car. People traded the perceived obvious risk, for another risk that they were not even aware of at the time.

Second-order thinking with risk

In the above example, the people who picked cars over flying likely did not engage in second-order thinking. They engaged in first-order thinking, which was simply deciding that air travel was too risky and the only solution would be to drive instead of fly. Second-order thinking is a deeper level of thinking and would have involved mapping out the outcomes that could come from driving.

This blog post by Farnam Street beautifully describes the relationship between first and second order thinking:

First-order thinking is fast and easy. It happens when we look for something that only solves the immediate problem without considering the consequences. For example, you can think of it as; I am hungry so let's eat a chocolate bar.

Second-order thinking is more deliberate. Second-order thinkers ask themselves the question “And then what?” This means thinking about the consequences of repeatedly eating a chocolate bar when you are hungry and using that to inform your decision. If you do this you’re more likely to eat something healthy.

When we think about the longer term consequences of constantly turning to a chocolate bar to solve our hunger problem (weight gain, increased chances of diabetes, impact on our heart health), we usually will opt for something healthier. When we frame our decision with a longer term lens and think about the non-immediate outcomes, it changes how we make decisions. We think less about the immediate impact and more about “then what” impacts.

How to view risk

So, if we know that risk lies in the things that we cannot see and that we typically gravitate towards first-order thinking, what can a person do? If we refer back to Morgan Housel, he says it best in this blog post:

Risk gets ugly when you think it requires a specific forecast before you start preparing for it. It’s better to have expectations that risk will arrive but you don’t know when or where than to rely exclusively on forecasts – almost all of which are either nonsense or about things that are well known.

It is hard to properly calculate risk as we tend to focus on the obvious risks, but it’s the unseen risks that sneak up on us. If we think about our current environment, things appear pretty gloomy. It’s likely that few of us would have predicted that a virus would leave millions unemployed, cause an unprecedented drop in stock market values and leave humanity in a state of fear. This was a risk that wasn’t planned for, at least not by the majority of people.

However, the current situation might change our behaviours going forward. It might cause a younger generation to have higher savings as they witnessed the devastation that can be caused from not having an emergency fund. It also might change the way people shop and keep extra food on their shelves or freezer. Or, it may change how people invest for the long-term.

Impacts of Second-order thinking

If we zero in specifically on the investing decisions, let's see what second-order thinking can tell us about some of the potential unseen risks.

While a new generation of savers is never a bad thing, there may be some potential second-order consequences.

It could be possible to over-save

Having anything more than a year's worth of life expenses in your chequing account doesn’t make a ton of sense if you are hoarding cash but not investing for your long-term goals. While the immediate impact of cash on hand is great, the consequences down the road can include not saving enough for retirement, missing out on life experiences from not wanting to spend money and the economic impacts of not spending money in the economy.

Jumping on risky investments

For investors, now might seem like a great opportunity to jump into riskier investments due to the low valuations. While the immediate effect might be higher short-term returns, the long-term implications might not be so favourable. If an investor was not invested in riskier investments before the markets declined so rapidly, they likely are not an appropriate investment now. The riskier investments will have higher volatility (price movements) and that is not something every investor is comfortable with.

When we think about the second-order consequences for these riskier investments, we may find ourselves asking the following questions:

• What happens if you invest in this new fund or individual equity and in a year or two the volatility makes you nervous and you sell?
• Or what happens if the investment product never reaches a new high?
• Would you be any better off than if you had just stuck with your original long-term diversified plan and added money to that strategy? Likely not.

This begins the emotional life-cycle of investing. The jumping in and out of the market based on when it feels good to invest can erode capital making it more challenging to earn your long term goals. The second-order impacts could be, less money saved for retirement or your long term goal, increased taxes paid (if investing in a non-registered account), more emotional swings and less effective compound growth.

Weathering the storm

One of our equity sub-advisors is famous for saying, “the middle of the storm is not the time to fix the ship.” Once we make it through the choppy waters and make it safely to land, then it may be the time to make portfolio adjustments.

If, during this current storm, an investor realizes they really dislike volatility, more bonds should be added to their portfolio so that the next time we face volatility, it will be a smoother ride for them. If portfolios are adjusted, an investor’s financial plan should also be adjusted to account for those second-order impacts of the change. This might mean working an extra year or two or less discretionary spending to account for slightly lower long-term returns.

The most important second-order outcome from making that adjustment (or even third-order outcome) is setting yourself up for success for the next time we are in the middle of volatility. It will happen again and we can help protect our emotions and hard-earned capital by being prepared and planning for the next unknown to hit our economy and stock markets.