The Consequences of Risking Everything

In life, there are things, and there are treasures…

Things are common. Treasures are rare. A few days ago, I lost one of my treasures – a cat named Uzi. Yeah, I know, Uzi was “just a cat.” But that reality did not make her any less of a treasure. In so many different ways, that little cat made me smile…or laugh. She was just a cat, but she was precious to me…which is why I spent hundreds of hours during the last two years 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. Three nights ago, the worst came to pass. I searched for Uzi off-and-on from 5:00PM until 2:00 AM. 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 I will spare Daily Reckoning readers a feline eulogy. Uzi was, after all, “just a cat.” Accordingly, some Daily Reckoning readers – probably the dog-lovers in the crowd – may be saying to themselves, “Wow! Eric’s behavior is a little extreme. Why the big to-do about a cat?”

The answer is two-fold – one part personal, one part universal. The personal part is that I loved Uzi. The universal part is that asymmetrical risks demand extreme vigilance.

Investors take note…

First, let’s define our terms: An asymmetrical 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 fifty 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 asymmetrical. In our hypothetical 50-to-1 risk, Uzi returns to the house alive 50 times out of 51. 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 asymmetrical bets every day. They accept miserly yields, for example, in exchange for buying the bonds or preferred stocks of bankrupt, or near-bankrupt, companies. In the “Bailout Era” of American finance, risks like these have tended to succeed most of the time. But when they don’t succeed, investors lose everything. That’s not a smart risk.

Some asymmetrical risks are obvious – like playing Russian roulette…or buying a mortgage-backed security from a Goldman Sachs broker. But many asymmetrical risks are less obvious – like jaywalking at night…or placing 100% of one’s net worth in a single currency. In all likelihood, the jaywalker will cross the street without incident and the single-currency investors will suffer no harm for lack of diversification. But if the jaywalker happens to encounter a vision-impaired driver or the single-currency investor happens to encounter an imprudent government, something bad will happen…something very bad.

We investors cannot afford to turn a blind eye to risks, especially not to asymmetrical risks. We investors cannot afford to take risks that are likely to work, but are likely to wipe us out if they don’t work.

Understanding your potential rewards is worthwhile. Understanding your potential risks is everything.

Eric Fry
for The Daily Reckoning