This image, from the Nintendo video game “Super Mario Brothers,” went viral on X/Twitter a few years back:
Translated from Japanese, the accompanying text says: “Even though they are essentially the same, they feel completely different psychologically.”
The side-by-side images, of course, aren’t identical. The one on the right has less real estate on the right-hand side of the screen (and no clouds in the sky), where the player would make the final jump.
The point stands, though—the four jumps on the left screen look less scary than the four jumps on the right screen, but they present exactly the same level of risk in the game. Importantly, I think, the “World” on the left is level 8-1. The one on the right is level 8-3, a higher, more challenging level.
I got to thinking about this in the context of investing, because there’s an old market proverb that the safe stuff is always riskier than the risky stuff.
(A version of this proverb, incorrectly credited to Mark Twain, was used at the beginning of The Big Short—the movie, not the book—and in Al Gore’s documentary An Inconvenient Truth: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”)
Generally speaking, risky investments are well-known to be risky, and most market participants have an eyes-wide-open approach to the risks. Perhaps positions are kept smaller, or are hedged, as a buffer. Contrast that with anything deemed “safe”—whether deemed so because of overconfidence, naivete, a low-looking valuation, or a psychological illusion. Its presumed safety can lull investors into a sense of security that prevents appropriate diligence or analysis.
Think about the role of bond ratings in the Great Financial Crisis, when investment-grade ratings were given to paper that turned out not to be investment grade. The U.S. Financial Crisis Inquiry Commission’s published report does not mince words:
We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms. [emphasis mine]
Or the concept of “portfolio insurance” back in 1987, which, as its name would suggest, was meant to protect investors, but ended up contributing to the Black Monday madness. From Marketwatch:
In 1987, so-called portfolio-insurance products, which were created to protect investors from falling markets, instead, helped exacerbate a breakdown on Wall Street that resulted in the largest one-day, stock-market percentage decline in history. Portfolio insurance, employing computer algorithms, was designed to limit an investor’s loss from a plunging market, while preserving upside gains in rising markets. It consisted primarily of derivative bets, and often involved using “stock-index futures in a rising market and selling them in a falling market,” according to “A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response” written by Mark Carlson [and published in 2006], then an economist at the Federal Reserve. [emphasis mine]
Asking what the biggest risks are is like asking what you expect to be surprised about. If you knew what the biggest risk was you would do something about it, and doing something about it makes it less risky. What your imagination can’t fathom is the dangerous stuff, and it’s why risk can never be mastered.
It seems to me that managing risk is a process without an end, an art rather than a science. The key, I think, is to be humble about what risks exist (even in so-called safer assets); be upfront about the things you take as granted; to try to be mindful of your own behavioral biases (or the psychological illusions designed to trick your brain); and realize that the true risks are hard to recognize ahead of time. Equities that appear to be “safe”—such as the Nifty 50 in the 1970s, to many eyes—may be among the least safe of all; and those that appear risky may be among the most promising and potentially less risky than average. It also depends on how you want to measure risk—we propose that stock volatility isn’t necessarily the most relevant measure. Business trajectory is.
Despite all the novel illusions embedded throughout, even I made it past Worlds 8-1 and8-3 in “Super Mario Brothers” (a very long time ago). At the end of the game, after beating the final level, “the player is rewarded with the ability to replay the game with changes made to increase its difficulty.”