On Additive Risk Management

I’m reading Mark Spitznagel’s new book (Safe Haven) and, as ever, it is proving to be a goldmine. Part 1.

On Additive Risk Management
Stormy Seas. Photo by JOHN TOWNER / Unsplash

Part 1 of an intermittant series babbling on about Mark Spitznagel's Safe Haven.

“People think of risk mitigation as a liability, a trade-off… because it usually is."

This trade-off mentality is the conventional way of considering risk—a form of thinking about risk mitigation that is perhaps more in-line with reducing what I like to call “engineering risk.” Useful, in the right time and place, like if you're building a bridge. This is the “overbuild and underpromise” mindset—good when you’re trying to build robustness and safe margins for error into reasonably well understood systems under normal conditions.

But there are a lot of aspects of life that aren’t covered by those caveats. Spitznagel’s domain is finance, which is a complex, poorly understood system at the best of times, and I think it’s fair to say that as our globalized, interdependent, interconnected, etc. etc. situation has developed, the situation is less and less “normal” compared to the field’s background. Analyzing a single decision-making cycle can obscure the real outcome space.

Anyhow, in order to shift this perspective of risk management as a pure cost or trade-off against a future outcome, it’s important to begin to understand that the future is the product of a sequential process with repeated decision making points that need to be undertaken in uncertain conditions, because forecasting isn’t cost-effective in the long run (it's "fragile"). Considered from this perspective, properly mitigating risk in complex systems isn’t about merely overbuilding and adding extra robustness. It's about slashing your exposure to downside risk while increasing optionality, e.g. it will actually let you take on more in the form of upside exposure.

In finance terms, Spitznagel is pursuing risk management that is additive to a portfolio’s long-run CAGR, rather than subtractive from it. It might decrease returns at any given decision-point, but over the iterative lifespan of the investment it increases returns.

It’s quite interesting to think of the ways this might manifest outside the realm of finance. What other systems find themselves in need of increased optionality and decreased exposure to major downside risk over the long run? Where else are we looking for safe havens? I can think of shedloads, from the macro-scale: politics and our climate future to the micro-scale: personal growth (eudaimonia) and professional satisfaction both seem to depend on the occasional “big breakthrough” (in whatever form that takes for you) as well as insurance against the worst systemic outcomes.

“You see, a cost-effective safe haven doesn’t just slash risk. It actually lets you simultaneously take more risk.”

In the next bit of the book we'll get into a more concrete example and some spicy philosophical background—stay tuned!