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Neglecting tail risk

It's not just governments that neglect the risk of disaster. So too do investors and company bosses
Neglecting tail risk

Critics of the government say it was unprepared for the Covid-19 outbreak by having insufficient ICU beds, protective equipment and testing kits. What makes this charge plausible is that it is common to ignore tail risk – the small chance of disaster – not just in government, but in finance and industry as well.

Nassim Nicholas Taleb has called this “picking up pennies in front of a steamroller”. Sometimes, we can get a small regular income stream by exposing ourselves to the chance of catastrophe. Ensuring that the NHS was working flat out, for example, held down taxes for years, but left it under prepared for a pandemic.

We saw the same thing in the run-up to the 2008 financial crisis. In the mid-2000s, AIG sold insurance against defaults on mortgage derivatives. For months, it earned steady profits. But then those derivatives did default, leading AIG to need the biggest government bailout in history. Similarly, Northern Rock expanded by borrowing in the interbank market. That worked until the hitherto-unthinkable happened and the market froze up, leading to the first run on a UK bank since 1866.

Those weren’t the first cases of companies ignoring tail risk. In the 1980s and 1990s Equitable Life attracted investors by paying out big bonuses by keeping its reserves low and by selling guaranteed annuities. That worked for years until annuity rates fell, causing those guaranteed annuities to become so expensive that the company went bust.

Nor did the financial crisis put an end to the neglect of tail risk. From 2013 to 2017 the XIV ETF quintupled its investors’ money. But then it lost everything in 2018. It was selling insurance against a rise in market volatility. For as long as volatility stayed low, it earned insurance premia. But when volatility rose in early 2018, the steamroller ran it over.

Experts had warned of such a thing. In his book, Hedge Funds, written in 2008, Andrew Lo at the Massachusetts Institute of Technology (MIT) showed that selling insurance against a stock market crash could reap good long-run returns without any skill until the crash actually happened. He wrote: "Shorting deep out of the money puts is a well-known artifice employed by unscrupulous hedge fund managers to build an impressive track record quickly.”

The collapse of Neil Woodford’s funds, in retrospect, conforms to this pattern. In holding illiquid unquoted companies he was taking on a form of tail risk – the danger that a wave of redemptions would force him to sell too many good stocks. And this risk eventually materialised.

It’s not just financial companies that have neglected tail risk, however. So too have non-financial ones. Under Lord Browne, BP’s profits rose thanks in part by squeezing spending on safety and maintenance. That worked well, until the Texas City refinery blew up.

Faced with the charge of being ill prepared for disaster, the government does at least have a lot of co-defendants.

Which poses the question. Why do people neglect tail risk? An obvious possibility is simply that they misjudge risk, thinking it smaller than it really is. The tendency for bosses to be overconfident and overoptimistic reinforces this.

This answer, however, runs into a problem. Benjamin Enke and Thomas Graeber have recently showed that we often overestimate small probabilities, which implies that we should be extra-careful about tail risk. So why aren't we?

Some recent experiments at the University of New South Wales suggest an answer. Elise Payzan-LeNestour and James Doran asked people to bet or not upon whether an archer would hit a target, winning $2 if he did, but losing $40 if he missed. They were told there were two types of archer – skilled and unskilled – and shown their past shots. It was clear that it paid to bet on the skilled archer, but not on the unskilled one because while he would often hit the target he missed often enough that one would lose money on him over time.

Even when they knew the archer was unskilled, however, subjects continued to bet on him hitting, and so lost money. Doctors Payzan-LeNestour and Doran show that this wasn’t because they liked a gamble or were trying to make up for previous losses. Instead, they say, it’s because subjects had become addicted to repeated small wins (all those $2s) and so continued to chase them even though doing so entailed big risks.

You might ask: does this laboratory result apply to the real world? I fear so, because the addiction is reinforced by social pressures. This was famously recognised by Charles Prince, then-CEO of Citi, in 2007 when he said “as long as the music is playing, you’ve got to get up and dance”. He knew he was taking risks, but pressure from shareholders compelled him to. That wasn’t an isolated example. Equitable Life, Lord Browne and Neil Woodford all earned stellar reputations. Similarly, the Conservatives have for years been well rewarded electorally for leaving the NHS underprepared.

It’s tempting to infer from all this that the need for small regular rewards to the neglect of the chance of disaster is hard-wired into us.

It’s not. Doctors Payzan-LeNestour and Doran found that when subjects were given the option of pre-committing to not betting on the unskilled archer, many took it. Like Ulysses binding himself to the mast to avoid being lured onto the rocks by the Sirens, they were smart enough to save themselves from temptation. In finance, we have analogous mechanisms: I use large cash positions and tracker funds to save myself from my many stupidities. In politics, however, we do not. Perhaps, then, the government’s lack of preparedness is a failing of structures and not just of individuals.