Good Neighbors

By Matt McPheely

⚠️ Risk: The Full Picture

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Good Neighbors
Welcome to the Good Neighbors Newsletter - where we’ll explore the ways in which real estate development and entrepreneurship can combine as a force for good in our neighborhoods.
Below you’ll find 3 sections: (1) A Few Things Worth Sharing, (2) An Exploration, and (3) The Watercooler.
The “Exploration” section is typically an essay challenging how we think about our places, our neighbors, our work, and our future. And “The Watercooler” is for project updates for those of you wanting to keep up with how these ideas are playing out in the real world. Feel free to jump to whatever is most interesting to you, and thanks for joining me on this journey!
⚠️ Risk: The Full Picture
Most people think they know what “risk” is. But actually defining it is a harder exercise than you might think. It’s a bit like Ted Lasso when asked to define offsides in soccer: “I’m gonna put it the same way the US Supreme Court did back in 1964 when they defined pornography. It ain’t easy to explain, but you know it when you see it.” Except everyone sees risk differently and it depends on the situation. This should be fun.
Foundation
Here are a few definitions I could find in my research:
  1. Risk = volatility
  2. Risk = uncertainty
  3. Risk = the probability of permanent loss
  4. Risk = more things can happen than will happen
  5. Risk = not getting what you want
There are overlaps in these definitions, but I could use each to justify various completely different decisions. If I’m a banker, I’d rather be certain of a small loss than have an equal chance of gaining or losing 10%. So I’d probably lean on definitions 1 and 2. If I’m a 24-year-old investment banker making $400k/year, I probably care much less about volatility, so could lean more heavily on avoiding loss over a long time horizon.
Kris Abdelmessih makes the point well here:
The concept of risk is useful insofar as it helps you judge the merit of an investment. No single measure of risk is sufficient. Think of risk as a multi-faceted prism. The same investment projects different qualities depending on which angle you view it.
The only definition that encapsulates this idea is #5, from this short article by Taylor Pearson. Risk is not getting what you want. You only know what’s risky in the context of what you want. If you owe $50k to the mafia by next week, you probably want to avoid a baseball bat to the knees more than you want to avoid loss through a well-diversified long-term strategy. If you want adventure, a desk job at an accounting firm is risky.
The Real World
We’ve determined that risk is contextual, and your definition must be useful to you above all else. But here’s my problem: I still have no idea what to actually do with this. Life is not a flip of a coin where the probabilities are known. It is messy and complicated and there are an infinite number of variables to every situation. Even when we think we understand the probabilities (real estate is a safe investment, crypto is the future, etc), we really have no idea. As John Maynard Keynes pointed out, “A proposition is not probable because we think it so.
So how do you actually calculate the probability of not getting what you want?
Howard Marks says it well in his memo on risk:
If risk = uncertainty, and all of life is unquantifiably uncertain, then we are simply left with dealing with the future rather than predicting it.
So if we can’t predict the future, only deal with it, what does that look like on a practical level?
It may help to first outline a few different types of risk and make this more concrete. Many of these are referenced in Marks’ memo:
  • Risk of permanent loss - this is what most of us probably think of first. The risk of losing your money, your job, your [insert important thing here].
  • Risk of falling short - a.k.a. the risk of not taking enough risk. If you freeze, you miss opportunities and get left behind. This outcome is not too different from permanent loss.
  • Specific Risks - These are the risks typically associated with financial instruments, but can usually be applied to other aspects of life as well:
    • Credit risk - likelihood a borrower will pay you back as planned. Banks have a very narrow view of credit risk, and there is upside opportunity in broadening the way we look at this. Yes, I’ll take any opportunity I can to say it: banks need to update their views on credit risk
    • Illiquidity risk - the extent to which your options are limited because your investment is locked up. This makes diversification extremely important - in this case, having enough liquidity elsewhere (or ”dry powder” as they say in the biz) to be nimble and adapt to a changing environment (see principle #4 below)
    • Concentration risk / Over-diversification risk - too much of one thing will kill you quickly if the winds change even slightly…but adding in too many different things will slowly kill you with mediocrity
    • Leverage risk - similar to concentration risk. Adding debt magnifies speed and volume of both upside and downside
    • Funding risk - when timelines are not aligned. Borrowing short-term funds for a long-term investment presents an opportunity for an otherwise good deal to die
    • Volatility - fluctuations can wreak havoc on our emotions, leading us to do silly things like buy high and sell low. And as Marks points out, it’s often “very hard to differentiate between a downward fluctuation and a permanent loss.” So we end up selling volatile investments at exactly the wrong time
    • Model risk / Black Swan risk - It’s nearly impossible to model out extreme events. Models tend to show you the average outcomes. But even if you model a 100-year timeframe, you miss the 1000-year event. We’ve seen a few of these already in the last 15 years. Someone told me recently a great saying about a 6-foot-tall man who drowned in a river that was 5-feet deep on average
    • Manager risk - taking advice from the wrong person
    • Career risk - looking foolish in your job
    • Headline risk - looking foolish in public
How do we possibly manage all of that? Especially when those risks are sometimes contradictory and often hidden, only to reveal themselves when disaster strikes.
Here are a few practical principles that apply to risk management in our daily lives, whether in regards to a financial investment, our jobs, relationships, or habits:
  1. First figure out what you want. You don’t actually know what’s risky until you know what you want. And most of us don’t. We tend to be blown by the wind, or adopt someone else’s (parents, teachers, journalists, other “successful” investors) idea of what’s important.
  2. Practice detachment. Many of these risks above come into play when our emotions control us. It’s easy to imagine someone who is so certain of an outcome he modeled that he is heavily-concentrated and heavily-leveraged in order to magnify the returns he imagines. And when the winds change slightly, he fears looking foolish, sells for a substantial loss, and down the rabbit hole he goes. We must not fall in love with our ideas. We must acknowledge that the future is unknowable, and our identity is not tied to our mistakes. Detachment requires humility, but mostly it requires awareness. On that note, this book is a must read: Awareness by Anthony De Mello.
  3. Actual risk and perception of risk are often inversely correlated. Howard Marks mentions this a number of times in his writing. Often, what makes something high risk is the very fact that too many people think it’s a sure bet. Think about the housing crisis in 2008 - enough people believed real estate only goes up in value, so they started doing crazier and crazier things based on that belief. Act accordingly.
  4. Stay nimble → become resilient. This may be my biggest lesson learned of the last year.There is no substitute for being able to adapt to changing environments. This can be done with cash (aka dry powder, pow-pow, chowda, juice, green smoothie, bag o’ hundies) ready to spend on lower prices after a downturn. Or you can create cash for this by selling a liquid and truly uncorrelated asset. Taylor Pearson does this by investing long volatility with his Mutiny Fund, which is essentially a bet that the good times will end one day. And when they do, you need to have something you can still sell or spend. This will require more than your typical stocks & bonds, and more than your seemingly safe job and 401k.
  5. Find your edge. Don’t play with sharks. Even sharks don’t play with other sharks - they find the tuna. There are two lessons here: 1) Realize that you’re usually the tuna, and 2) in this world, sharks are made, not born. Sharks are those who have found their edge. It’s where they’ve spent their thousands of hours, have developed pattern recognition and intuition, and can calculate probabilities with greater accuracy than others. They can’t predict the future, of course, but they can manage it better than the rest in the areas they have an edge. By definition, they’ll do things that others (the tunas) view as “too risky,” and will be rewarded more often than not because they’re playing a different game. The biggest risk for the shark? Overestimating their edge (see point #2).
Now go forth, my nimble, detached, resilient shark friends, and if you find yourself with some chowda and nowhere to put it, I’ve got some ideas :)
Shout out to some great discussion partners from On Deck Investing: Cristin Pacifico, Ben Erlich, Kyle Griffin, Nathan Percy, Andrew Bean, Tom White
Project Progress:
Finally, the little share button below is the Good Neighbors version of bringing over a tin of cookies to someone who just moved in across the street. You want to be a Good Neighbor, don’t you?? :)
Until next time,
Matt
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Matt McPheely
Matt McPheely @mattmcpheely

The Magic of Places and How To Build Them

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