How to master risk and uncertainty

Life is uncertain. We can take precautions and do things safely but we can never be sure what will happen. Whether we take an exam, accept a job, move house, move countries, marry, have kids, change careers, invest, trade, speculate, nothing is certain.

Sometimes we do not have enough information and sometimes the outcome depends on a lot of complex things which are impossible to predict. Therefore there is always risk. We are always exposed to the consequences of uncertainty in many, if not all aspects of our life.

We cannot stay quiet and not act. We have to act and even if we do not do anything, we have acted by not doing anything. We can make what we think is the ‘right’ decision and things could still turn out badly and we can make what we think is the ‘wrong’ decision and things could still turn out well.

We can do things slowly taking account of all the information we have and what wise people have said before and we might avoid most risk. We cannot avoid all risk. If we decide to things faster, we have to risk failure. Otherwise we cannot learn and do quickly.

Right answers do not always exist, there often is no best solution, and the proper course is often obvious only in retrospect. Seek the truth about your situation and continually track its status. Don’t put all your resources into implementing the right plan. Keep some in reserve for when your original plan does not work out. Don’t be surprised by the failure of your original plan. Instead, actively seek evidence that your original plan was off the mark before any indications to the contrary arise.

This is true of all aspects of life, including investing, trading and speculating.

There are seven rules that we can use to manage risk and uncertainty in life, including investing/trading:

Overcome fear: Master your fears and act decisively when needed. If you don’t do that, fear can make you avoid taking risks and make you bury your head in the sand when things don’t go the way you expect them to. This will lead to loss and not gain.

The way to do this is think of the three components of fear

  1. Novelty anxiety: fear of something new. The way to get rid of this is to  keep doing the thing you fear. Start small and under supervision and then gradually expand.
  2. Irrational anxiety: irrational fear of doing the thing. The way to get rid of this is to do things slowly and step wise( systematic desensitization) or to just expose yourself to the thing( flooding)
  3. Inherent threat anxiety: fear of the risk that is the nature of life. You just have to realise that this is always going to be there, no matter what you do.

Remain flexible: When you don’t know what is going to happen, the best strategy is to be ready for everything. Look out for different places to do the things(diversify your markets) and different ways( diversify methods) to do things.Control your position size( how much you risk in each market and method)

Experiment. Do different things. Use different approaches. Adapt and change depending on what is working and what is not.  Make sure that your plans account for  the future will bring something you cannot anticipate.Do not forecast what will happen but respond to what is happening and what did happen.

Take reasoned risks: Do not put too much at stake. Take educated guesses. Have a reasonable exposure so that you can make a good return but do not lose everything and trade with odds in your favour. Don’t overtrade/overexpose yourself. Don’t miss a trend and ride them. Balance risk- not too much, not too little. Just enough. Risk might be unexpected, large and difficult to escape. The amount of risk you are willing to take is personal as well as to how much you are willing to lose.

Prepare to be wrong: What matters in the end is the total money/wealth won and lost, not whether you are right more than wrong. So you have to be comfortable making decisions which can become wrong.You have know what you will do if it goes wrong. Be wrong early. Be wrong often. Diversify the risk. Have a plan B. This is because you just don’t know what will happen.

Actively seek reality: You have know what is happening and what to do to prevent losses from getting worse. Search for it, dig for it, hunt for it, and pry it up even.

Respond quickly to change: Once you know that change has happened and you have to respond, you have to respond quickly and immediately. If you wait, you will lose more.

Focus on decisions, not outcomes. Have specific strategies and rules and a plan. Once you follow them what happens is immaterial, it is not within your control. Remember that luck and random chance influences a lot in life.

These rules when applied to trading gives us the following lessons:

  1. Trade with an edge. Find a trading strategy that will produce positive returns over the long run.
  2. Manage risk: Control risk so that you can continue to trade, or you may not be around for the long run, and then you won’t see those positive returns.
  3. Be consistent: Execute your plan consistently to achieve the returns.
  4. Keep it simple: A simple plan or idea will hold up better over time than a more complex one.

Three things to avoid are:

  • Outcome bias: Judging the outcome and not the quality of the decision
  • Recency bias: Weighing the most recent data heavily and not considering the whole data
  • Belief in the law of small numbers: Place too much significance on a relatively small number of events within a larger context, when it all might be just chance.

notes from the book, Inside the Turtle Mind- How the world’s best traders master risk by Curtis Faith

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