# Risk and Reward, from Duncan Coker

September 8, 2010 |

A small example of risk and reward played out this morning. I live near the ocean and woke near sunrise to surf. There was a gentle rain but not a problem. As I get to the water I look out to glassy waves and a light rain, but far out on the horizon is a storm, which will probably not reach here, but a storm none the less. Then, there was a large lightening bolt that lit up the sky to the horizon and thunder. Do I surf or head home? The getting up early, driving here, getting ready, are all sunk costs, and irrelevant. I do a quick analysis of the risk/reward, but have no real data to back it up. What are the odds of being struck by lightening in the water within 10 miles of a storm? I guess, probably over 1 in a million. Does this increase with more time in the water?, My estimation is yes. Is it dark and intimidating looking? Yes, but probably irrelevant. So I decide to risk it. I catch just a few waves then head in after maybe 30 minutes. Was it just a bit more exhilarating because of the pending storm then just a normal day surfing. I will admit it probably was.

According to the wife of his old colleague Croker, the Duke of Wellington had his own discipline of risk-opportunity analysis. "All the business of war ", he told Mrs. Croker, "and indeed all the business of life is to endeavor to find out what you do not know from what you do." Wellington's phrase for it was elegantly simple: "guessing what was at the other side of the hill". (Arthur Wellesley's genius was to use terrain to spare his troops from the murder of the French cannon; he had his troops lie down during bombardments on the reverse slope of hills, where the spotters could not see them. This "cowardly" tactic was ridiculed by Napoleon - himself a gunner, but it was soon copied by the more intelligent French generals. That is the further implication of the Duke's maxim: your wise opponents will steal your best ideas.)

Duncan,

What you have hit upon is the peephole to an entire discipline I call "Risk-Opportunity Analysis."

It explains, say, why we will get onto an airplane even though there is a (very small) probability that it will kill us. It explains, mathematically, why we do such things, and shows the mathematical reasoning for such. It can be extended then to trading, how much to risk, etc.

The conventional notions of assessing risks do NOT address this, and, in my opinion, as proved through the tenets of Risk-Opportunity analysis, are just plain wrong.

Incidentally, and forgive my plug here, but if anyone is interested in this, I am having a 2 day course in Tampa and in Tokyo in the next two months, and you can learn more at ralphvince.com

## Pitt T. Maner III writes:

Would one change actions if more information or warning was available? How does real time information play in and can one truly interprit it properly and realize the statistical significance. 1:1 million odds can change when the strikes per minute count starts to climb. These alarms can be pretty unnerving.

Normally in the health and safety field if one sees a strike then you wait about 30-40 minutes and continue work if no other strikes are seen in that time interval— its a real rough rule of thumb and hardly perfect. Some go with a 6 mile radius for the detectors. Lightning risks are considered higher if they go within that radius.

For the alert-based systems though there are a lot of factors to think about.

By the way, that Tampa area is considered the "Lightning capital of the world"

I have heard of projects being shut down over there when lightning was detected by multiple detectors within a 20 mile area because the storms can move so quickly and/or the bolts generated can cover that distance too. So it can be difficult to work outside in Florida in the summer when following a strict lightning policy.

But in South Florida we get these too— out of clear sky.

## Rocky Humbert writes:

There is a huge corpus of literature that shows people's instinctive assessment of risk and reward often have little to do with the HISTORICAL probabilities. Charlie Munger gave a long-winded speech at Harvard in 1995 on the "Psychology of Human Misjudgment." And as Ralph knows, "Risk-Opportunity Analysis" is not just about trading. It encompasses everything from physical System Fault Tolerance/Reliability (my dissertation topic) to classical economic utility theory to government/regulatory policy. And don't forget Pascal's Wager either!

Most people live (and die) in the middle of the curve. And the rest live (and die) in the tails. I'd argue that the wise man should try to make decisions which maximize his eternal happiness, and ignore the statisticians and meteorologists…or as Ed Seykota supposed said "Everyone gets what they want out of the markets."

## Ralph Vince responds:

Pitt,

Yes, with new information, you have a new starting point from which things can change with given probabilities. The things that might happen, and their probabilities may be the same, but you have a new frame of reference, a new starting point. Think of a horse race, where you can change your bet at the first turn.

Rocky,

Very true, and that corpus is very interesting for a host of various reasons.Usually, we find, there is an often not-so-obvious logic to people's choices even though they appear inconsistent with historical probabilities.

But what I am alluding to — the inescapable conclusions I have found myself in — there is a lot more to it than that, and it;s a big can to open up here. In retrospect, it's all very obvious, and I can look at it and say to myself, "Yes, of course, this is obvious to me now."But it isn't obvious in the main, and frankly, from the polling of people I have been doing, not obvoius to anyone at all, which is the MOST peculiar thing about all of this.

As is often the case, some answers can be evaluating using limiting cases. For example, you will never die in a bicycle accident if you never ride a bicycle (approximately).

As health care provider, I note frequently patients express regrets about having done something (or not doing something). The nature of regret seems to include a miscalculation of what consequences will actually feel like were they to occur. ie, the vague consciousness that you might crash your bike feels different than thoughts about the future while traction is decompressing your spinal cord.

Part of the intellectual maturation process is the effort to improve estimation of the experience of untoward consequences.

Jim Sogi replies:

Duncan, I've surfed in gnarly thunder lightning storms and wondered the same. The surf tends to be good and uncrowded as the storm cold front pushes, and lifts the wind towards the sea making the winds offshore for a while which is good for shaping the waves. In addition, the storm front may be pushing a wind wave front. What I've since found out is that the lightning can travel over the surface of the water until it finds something grounded. Not good. I've read about mountaineers stuck on the mountain during a thunderstorm. They describe some weird effects where their tools turn blue and their hair stands on end. The lighting can travel over ungrounded surfaces looking for ground. I think in the water if there was a nearby hit, I'd hold my breath and go underwater and allow the bolt to go above me. Also, I would NOT sit the furthest out to sea. In general, if the storm is isolated, the risk reward would be good. I try to take that approach trading as well. Similar but different analysis for sharks. I'll post about that later.

There is usually a time window. Before Hurricane Iwa hit here in 82, just before the storm hit, there were 20 foot waves, with offshore winds early that morning. Only a few spot were able to hold the swell. There were only 3 guys out. At about 10 am the wind turned and things got ugly. We hunkered down but were happy to have taken the risk and rode epic waves I still talk about to this day.

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