Risk Management, The Pirate Way

As a child, I harbored a secret desire to be a pirate. Of course, I meant the Captain Jack type of pirate, rather than the Somalian type. Lots of adventure, sailing strange seas and Why is the rum gone?

I never became a pirate outside of a computer game (Sid Meyer’s Pirates! Anyone? Anyone?). But I did spend some time working in the shipping industry. It was a fascinating experience in many ways, and I learnt some things that have stuck with me.

For example, a ship architect once told me that you do not build a ship to survive the 99.9% of days when the weather is fine: You build it to survive the 0.1% of times it is trapped in a massive storm (or, perhaps, being fired upon by the Royal Navy).

That is a good analogy as to why many risk-management models, for example Value At Risk, are insufficient. VAR models give a reasonable insight into what will happen on most days, but it is the extremes that will leave you living in a cardboard box under the freeway.

If you are managing money for someone else, it might be logical (if slightly immoral) to build an investment vessel which ignores, or even sells, the tail risks. However, if you are investing or trading for yourself, you cannot afford to pretend that 100-year storms won’t appear ever 6 years or so.

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  1. Tuesday links: reasonable insights - Abnormal Returns | Abnormal Returns

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