Saturday, May 12, 2012

When the Dog Bites and the Bee Stings:
The Pitfalls of Underestimating Risk

Charles J. Givens was a businessman, speaker and bestselling author of books on financial literacy such as "Wealth without Risk."

One of the personal finance strategies Givens recommend was dropping some forms of automobile insurance coverage. He claimed that uninsured motorists coverage was duplicate coverage already included in life, disability or health insurance. Givens also advocated a philosophy of buying enough insurance to cover "real risks, not statistically improbable risk."

Gary Rinker of Anderson, Indiana followed Givens advice after attending a seminar run by the Givens organization and dropped his family's uninsured motorists coverage. Unfortunately, the Rinker's teenage daughter Kara was involved in an accident with an uninsured driver and became permanently disabled. The Rinkers filed suit against Givens for negligence and fraud. Givens ultimately faced multiple lawsuits for giving bad insurance advice—at least one of which was settled out of court.

Evidently, life, disability and health insurance is usually insufficient to cover the risk of catastrophic permanent disability resulting from a major car accident. And the larger message is that the whole point of insurance is to cover the risk of improbable events. If we pay a premium we expect to take a small loss but insure against a very large loss.

There's a big difference between an improbable risk and zero risk and that's a distinction that's important to consider. It's easy to focus on the short-term tangible savings on the premiums without considering the longer-term, less tangible risks of catastrophe. Because improbable risks aren't expected to materialize we may become dismissive of them and fail to think through all of the implications of things going wrong.

The other factor to consider is our ability to accurately predict the probability of "low-probability" events.

The story of the hedge fund Long Term Capital Management (LTCM) provides a lesson on the importance of considering downside risk. In its early years LTCM did well for its investors by arbitraging assets and using high amounts of leverage. Its board of directors included Nobel laureates and the fund had a prestigious reputation. But the fund suffered huge losses in 1998 following the Russian financial crisis. The LTCM fund managers were unable to ride out market volatility generated from the Russian financial crises because they were highly leveraged—they were at the mercy of their lenders—not to mention clients who wanted to redeem their shares. It ultimately had to be saved by the Federal Reserve Bank and the fund closed in 2000.

To quote Alice Schroeder's excellent book on Warren Buffet:
"Anything times zero is zero, Buffett said. A total loss is a 'zero.' No matter how small the likelihood of a total loss on any given day, if you kept betting and betting, the risk kept stacking up and multiplying. If you kept betting long enough, sooner or later, as long as a zero was not impossible, someday a zero was one hundred percent certain to show up. Long-Term [LTCM], however, had not even tried to estimate the risk of a loss greater than twenty percent—much less a zero. "

- Alice Schroeder, "The Snowball: Warren Buffett and the Business of Life"

The strong results that LTCM achieved in its early days were not the result of a sound strategy or smart managers but they were the result of an approach that took a great deal of risk.

Any person considering an investment or purchasing insurance should seek independent advice from a licensed investment or insurance advisor. Blog postings are for educational purposes only and do not constitute a recommendation for the purchase or sale of any security. The information is not intended to provide investment or financial advice to any individual or organization and should not be relied upon for that purpose.