The importance of embracing risk

Economist and technology analyst Bret Swanson published an important essay earlier this year entitled "Long Live the Risk-Takers."  It examines the vitally important subject of "risk," particularly from the economic perspective. 

While acknowledging that seeking to identify and prevent (or at least avoid) future problems is a valuable and necessary endeavor, the essay then asks:
What happens, though, when we develop a hyperfocus on shortcomings and potential losses?  What happens when we seek a public policy remedy for every perceived problem?  This kind of obsession with [eliminating] risk, danger and downside may be counterproductive.  It may exacerbate known problems and unleash dangers never dreamed of.

The danger, Bret Swanson argues, stems from the fact that in the real world, "Entrepreneurship is more likely than centralized economic management to produce innovation and wealth."  Entrepreneurship requires conditions which allow decentralized citizens, acting on their own initiative, to pursue their own goals, dreams, and creative impulses.  This kind of decentralization can be scary and unpredictable, and it will necessarily entail some failure.  In short, it is risky.

However, the article goes on to say that such risk is not merely a byproduct of innovation and growth -- it is a key component of innovation and growth, and it is in fact a beneficial part of the process.  Mr. Swanson writes:
Wealth is about creating new ideas.  New ideas can only emerge through experiments of science, technology, and enterprise, all of which must be capable of failure in order to generate newness.  Failure flushes away bad ideas and points us toward good ones.  The failures may at times harm individuals and waste resources -- people lose jobs and investments can be lost.  The larger effect, however, is to lift the economy to a higher plane of knowledge, efficiency, and resilience.
Central planners may be tempted to try to protect citizens from risk by implementing public policies that make it next to impossible for people to lose their jobs, but doing so can lead to a situation in which entrepreneurship is stifled and new businesses, new innovations, and new jobs are never created, all of which might have been created if conditions had been less stifling.  

As Bret Swanson's essay points out, this scenario is not hypothetical: many European economies have tried to do away with "risk" over the past several decades, only to throttle the ability of decentralized citizens, acting on their own initiative, to pursue the risky path of innovation and growth.  By trying to eliminate risk, danger, and downside, these countries have made their economies less diverse, creative, and resilient -- and now their citizens are suffering because of it.

In his most recent book, Knowledge and Power, visionary author George Gilder takes this observation even further, arguing that the expansion of wealth comes "through the conduct of the falsifiable experiments of free enterprises".  He explains: "Crucial to this learning process is the possibility of failure and bankruptcy." 

His book explores the importance of information and knowledge, and the fact that information is inherently decentralized -- meaning that dispersed individuals will always possess more information about certain subjects than even the most efficient central planners, and that therefore decentralized citizens must be allowed to act on their own initiative, and pursue their own goals and dreams using the information at their disposal.  In fact, in his book, he defines information at its most basic level as "surprise," which goes a long way towards explaining why central planners, even at their most efficient, can never corner the market on information and knowledge.

This subject, of course, has profound implications for the investor.  For one thing, we have long argued that investors should view their investing activities as the allocation of capital to businesses, and there are many ways that they can use the insights of George Gilder and Bret Swanson discussed above to seek out businesses that are creating "surprise" in their field.

Investors should become concerned when they see central planners moving in a direction that inhibits the ability of businesses and individuals to create surprise and (in Bret Swanson's words) "generate newness" -- a process which can only happen when there is a possibility of failure.  There are signs that, for a variety of reasons, central planners in many parts of the world (including the United States) are implementing policies that try to eliminate risk, even though such policies in reality only create bigger problems in the long run.

While investors may not have much control over the direction taken by policy-makers, they can and should consider the above discussion on the subject of risk, and realize that the temptation to try to eliminate risk can actually be more hazardous than embracing risk.  We have written on this subject in the past, such as in our article from June of this year discussing the dangers of municipal bonds (which many investors consider a sort of nearly "risk-free" investment), or this reflection from four years ago this month examining the reason investors think of venture capital investing as inherently more "risky" than real-estate lending, when in fact the opposite may be true.

In short, we believe that both Mr. Swanson's article and Mr. Gilder's book deal with an extremely important subject for investors to ponder deeply, and that both should be considered "required reading."  It may be understandable that at this point in history, elected officials and the investing public at large are reluctant to embrace risk.  Nevertheless, we believe that a correct understanding of the concept of embracing risk has never been so important.

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Don't Get Caught Up in the Fray!

As the calendar turns from summer to autumn the dreaded months of September and October, historically the weakest months for the stock market, are facing investors, there is plenty of outside news to make even the most steely market veterans queasy.  On the minds of most citizens in the United States, let alone investors, is the question of whether or not there will be an escalation of U.S. military involvement in the Middle East.  As of this writing, the Obama Administration is heavily lobbying the U.S. Congress to approve a strike against the Assad Government in Syria, apparently as "punishment" for the regime's use of chemical weapons against its own population.  We have no expertise in handicapping what the response of the Congress will be, and even less with respect to what the Obama Administration will ultimately choose to do, irrespective of the vote in Congress.   We will also not opine on the merits of such an "activity".

What we can say is that history is fraught with military endeavors and the market has either initially sold off only to recover shortly (1991 Iraqi invasion of Kuwait, Afghanistan War in 2001, Iraq War 2003), or it has ignored the actions altogether (U.S. and British bombing of Libya in 2011, NATO bombing of Yugoslavia in 1999).  For sure, the more prolonged a military conflict becomes, the more likely the market will react sluggishly, at best, or negatively, at worst.  It seems likely that any action taken by the U.S. against Syria will be short-lived and limited in consequences, at least in the short to intermediate term.  Therefore, we would expect the effect of any action on the market will also be short-lived.

The problem that this current pending military engagement presents is that it comes after a dozen years of prolonged conflict that the U.S. has been involved in both in Afghanistan and Iraq; and the citizenry, including the "investor", is weary of the danger that another prolonged conflict could be in store if action in Syria should go poorly.  It is very important that we make the point here that we believe war is NOT good for the economy, which is contrary to what many often believe.  Besides the obvious human tragedy that war encompasses, it strains the economy in that resources which would normally go towards investment in productive, entrepreneurial activity are instead redirected towards destroying things and killing people.  Sure, the defense industry may benefit, but this is the ultimate "zero-sum game".  We would argue that much of the reason that the market has struggled over the last dozen years is at least partially due to the enormous economic AND emotional cost of the wars in which the U.S. has been embroiled.

This is not an indictment of the defense industry.  Yes, there have been many technologies that have emanated from research and development in defense and have ultimately been commercialized, thereby aiding economic growth.  However, the most valuable of scalable technological advancements have come from private investment in areas such as microprocessors, software, and bio-pharmaceuticals.

What is most important to recognize is that while war may well have served to suppress the economy and market in recent years, the economy has managed to grow in spite and many more advances in technology have occurred in mobile, 3-D printing, biotechnology, etc.  And while the market has made little progress over the past dozen years, it is that very fact that likely means any significant downturn is less likely to happen, or to last long if it were to occur at all.  Therefore, as events unfold in the Middle East in coming weeks, regardless of what transpires, it would be wise not to get caught up the the "fray"!

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