Risk management is an area of finance that you’re probably familiar with. It’s about identifying threats and figuring out ways of either heading them off or minimizing their impact if realized.
This often involves lots of modeling and statistics, and it can be easy to get lost in the technical details. Underlying the mechanics of risk management are basic concepts of diversification and hedging. I have found it is worth taking the time to be precise about what those terms mean, even if speaking informally with clients, especially as informal risk management discussions are when trades actually get made.
An analogy that has worked well for me in these situations is that of homeownership.
Home ownership and risk management
Say you’re a homeowner, and the risk you are concerned about is not having anywhere to live due to a disaster, say a house fire. From a risk management perspective, you could:
- Stay undiversified: Buy one, really big house.
- Diversify slightly: Buy two, smaller houses on the same street. If something happens to one, hopefully, the second is far enough away that it won’t be damaged.
- Diversify a lot: Buy one house in New York and one house in Colorado. Whatever impacts one is very unlikely to impact the other. Until the zombie apocalypse—don’t believe the movies, this will travel fast.
Putting this into math terms, you can consider yourself diversified if your two assets have a correlation of less than one. Due to distance, the houses in New York and Colorado have a correlation of close to zero. Two houses on the same street have a correlation of less than, but nearly one.
In all of these home ownership scenarios, there is no sprinkler system, no alarm system, no fire extinguisher. Just trust that candles aren’t left unattended, and the electrical wiring is sound. In other words, there is no hedge.
Adding a hedge
Paying for and installing a top-of-the-range sprinkler system would be a sufficient hedge to protect the house. Sure, it may never be used making it an unnecessary cost, and sure it won’t ensure zero damage—your couch may get a bit wet, but that would just be a small setback compared to losing the entire property. In math speak, hedging is having two assets with a correlation close to -11:.
There is also a gray area of hedging; proxy hedging. This is a type of hedge used when a direct hedge isn’t available. So, using our house analogy, if a sprinkler system (the direct hedge) isn’t available, a proxy hedge is installing a smoke detector and hoping a good samaritan neighbor hears the alarm and calls 911. That may happen, but it also may not. There are so many unknown variables (are your neighbors home? Do they pay attention to alarms? Do the alarm batteries work?) that it’s difficult to know how effective this would be due to the indirect relationship. This would give a correlation of less than zero but noticeably more than -1.
Different diversification and hedging strategies are called for, and available, in different situations and being precise in their explanation during client conversations is worth the additional effort.
Exactly how do you figure out the likelihood and impact of a fire breaking out? Well, that’s where your risk modeling and calculations come in and will be covered in a future Smarts post. But email me at firstname.lastname@example.org if you need to know sooner.
My metaphor is starting to show some cracks here. But suppose you know that there will be no fire in your house, then the fair value of the sprinkler system is zero. If you know that there will be a fire in your house, then the fair value of the sprinkler system is the value of the house it will save. ↩
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