7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 2nd Deadly Sin – The Joy of “Risk”
(The following is one of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)
Lust (in the ecclesiastical world) – Even the Bible acknowledges the needs to “go forth and multiply.” Obviously, the Good Book didn’t mean a mindless search for passionless sex.
Lust (in the investment world) – risk (the sensual attraction to stochastic patterns for immediate gratification and/or justification at the expense of emphasizing long term goals by ignoring long term, and harder to quantify, trends.)
A Tale of Two Captains
The ocean waves grew larger with each buffeting blow. Captain Smith had crossed the Atlantic three times before on behalf of the London Merchants Guild. He had never before encountered such a ferocious storm. It began at three bells with a sudden gust of wind that blew the mate from the crow’s nest. Smith made the decision to ride out the tempest instead of skirting its edge. Looking at the oncoming wall of water, he now knew that choice would cost him and his crew their lives. Within seconds the ocean surge engulfed the vessel, snapping the main mast like a twig and driving the ship beneath the surface. At least it was quick…
Back in London, Captain Jones, a retired navigator now managing the affairs of the London Merchants Guild, has fretted for weeks after losing contact with Smith’s ship. Jones hired Smith to take some valuable goods to the colonies – goods sure to bring back profits ten times what the guild had paid for them, if they survived the treacherous trans-Atlantic crossing. Just then, a courier came in with a dispatch from a recently docked ship returning from America. Jones opened the note, though his gut already told him what it contained. The letter confirmed the discovered of debris from Smith’s ship. As Jones had feared, the worst had occurred. The entire ship – all hands and all cargo – lay buried deep in the ocean. His investment was lost.
The Tale of Two Risks
Who took on the greatest risk – Captain Smith or Captain Jones? Clearly, Smith gave up his life while Jones only lost his money. You can always get more money. You can’t come back to life once you’re dead. In experiencing the ultimate loss, we conclude Captain Smith took the greater risk. More importantly, we later find out Captain Jones’ loss was much less than what it initially appeared. He had obtained sea merchant’s insurance, a relatively new financial product now gaining in popularity among the exporters of England. With each voyage, Jones paid a small premium to the insurance company just in case his shipment was lost at sea. When the trip proved successful, Jones would only be out his premium. However, as in the case of the Captain Smith expedition, should the cargo be lost, the insurance company would remit some or all of the value of said cargo, mitigating much of Jones’ loss.
Risk in the Modern Investment World.
The plight of Smith and Jones defines the true nature of risk. One of the most damaging vestiges of the last generation or so of investment theory and practice is The 2nd Deadly Sin: The Joy of “Risk.” As opposed to improperly emphasizing risk, a good fiduciary knows risk tolerance (a.k.a. “loss aversion”) has nothing to do with the appropriate investment. But more one this on Part IV of the series.
What is the true definition of risk? If we harken back to the original definition of risk, a definition created during the onset of the insurance industry, we’ll see two definitions. Let’s start with what insurance means to the two parties involved in an insurance contract. From the insured’s point of view, insurance exists to reduce or eliminate risk or the downside damage in the event of an accident or calamity. From the insurer’s point of view, insurance means the house always wins.
With these different perspectives, we can arrive at the two definitions of risk. First, from the insured’s point of view, risk means not being covered and therefore not being able to receive a claim. From the insurer’s point of view, risk means covering someone and therefore paying the claim. From these definitions, we can deduce the most favorable outcome for each party. The most favorable outcome for the insured party means never being in the position of making a claim (i.e., live a healthy life). The most favorable outcome for the insurer means never being in the position of paying a claim (i.e., live a more profitable life). Oddly, then both outcomes are aligned.
So, how does this mitigation of risk work in the real world? We’ll concentrate on life insurance because it’s the easiest to understand. Life insurance is based on a series of actuarial tables. These are statistical summaries of the population’s patterns of behavior (like dying). For example, an actuarial table might conclude that in a population of 200 million people, 10 will be killed by lightning every year. An insurance company must first identify the Risk of Loss Potential, i.e., what’s the average coverage of each claim. In our example, let’s say the average person is insured for $100,000 and that everyone is covered. In the case of lightning deaths, insurance companies can expect to pay, on the average, $1,000,000 a year on claims (i.e., 10 x $100,000 = $1,000,000). We’ll call the calculation “The House Rules.”
For insurance companies to manage their risk, they must charge a premium which is just a little higher than the losses predicted by the actuarial tables. This slight premium increases reserves for those really bad years and allows for some level of profit. In our example, let’s say the insurance company wants to build a 10% (or $100,000) reserve every year and needs to clear $900,000 to cover expenses and make a modest profit. Based on the actuarial tables, the insurance company can expect to need $2,000,000 a year (after adding in the $1,000,000 in expected claims). To generate this amount in premiums, each person pays $1 a year for “Death by Lightning” life insurance.
OK, the above just counts on the law of averages to let nature take its course. Insurance companies, however, seek to maximize profits by controlling their losses. But this isn’t an example of some evil corporate demon, it turns out the best way for insurance companies to earn more profits means helping the insured people avoid getting killed. Loss Control employees teach people how to avoid getting hit by lightning by telling them not to do the following things during a thunderstorm: stand under a tree, ride a horse on the open plain, play golf, wear medieval armor while raising a flag on the top of the largest hill, etc… Here we have a classic win-win scenario that reduces the risk for both parties. It’s a scenario that avoids the ultimate risk for the insurer – bankruptcy – and the insured – death.
For centuries, that’s the way anyone but a gambler viewed risk. Gamblers don’t care about protecting the downside risk like every day folk. Gamblers only look at maximizing returns. For this, they look at the odds. Gamblers try to beat the averages. Contrast this strategy to the insurance company. The insurance company doesn’t try to outwit the actuarial table – it tries to actually change the table through education and smart living. Likewise, the insured doesn’t seek to beat the odds, they seek to reduce the odds of a catastrophic loss. Gamblers try to game the statistics. Insured and insurers try to change the statistics.
Next we’ll look at some of the traditional components of investment risk.
Part I: 7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 2nd Deadly Sin – The Joy of “Risk”
Part II: Investment Risk and the 401k Fiduciary: An Overview of Components
Part III: The 401k Plan Sponsor’s Dilemma – What’s Wrong With “Risk”
Part IV: Why Risk Doesn’t Matter to the ERISA Fiduciary
Part V: Risk and the 401k Investor: How Plan Sponsors Can Avoid Misleading Employees