Thinking Through Risk and Uncertainty: Contemplating the Coronavirus

“Without a structured approach to ordering the world, the world will impose its views on us. The fact is some things are more important than others, some things are easily verifiable…Simple processes help us sort the mess and prioritize.”

from “Managing Risk by Screening Out Trouble”

The coronavirus presents two specific risks to most of us. One, we transmit the virus to someone vulnerable (older, ill, or immunocompromised). Two, we or someone we love gets sick or injured in some other way and can’t access the health care system because it’s overwhelmed. These risks highlight the interconnected nature of the situation. Our individual choices affect others.

Given the risks, how do we contemplate a path forward?

We know what we don’t know.

This is a numbers game. And the numbers will get worse before they get better. In forestry, for example, trees planted years ago give us the forests we have today. Waves of trees can grow in massive booms. Foresters call this “a wall of wood” or “the pig in the python”.

With the coronavirus, the spreading that occurred silently weeks ago gives us the infections we have today. We don’t know the infection rate, which makes it difficult to know the pervasiveness, speed and, ultimately, decline of the coronavirus. What tells us we can return to normal? When we have smog alerts or forest fires or car crashes or hurricanes or food poisoning, we have metrics and indicators that signal “all clear!” Why? Because we have data.

We don’t know what’s knowable.

It does not matter if this situation is better or worse than people think, thought or said; it just is. And currently, we don’t know what “is” is. We can’t yet touch the bottom of the pool because we don’t know how deep the water is. We need data, and data requires testing. Each and every failure to deliver, offer, conduct, collect and communicate the results of a test reflects a small crime and failing in this battle.

Anything short of complete, ruthless transparency obscures our ability to know what is knowable, develop plans and support each other. From here, we can chart a path for our teams and help people make decisions for their local situations.

We know what to do.

In forestry, we have systematic approaches that apply generally to situations requiring clarity for making decisions. First, work to understand the local situation, as it varies by region and market. Second, question the data to understand its quality (e.g. seek trustworthy sources such as Johns Hopkins Coronavirus Resource Center). And third, make (phone) calls to know what’s knowable and confirm that people have what they need to follow the simple practices we know work well.

With a clear sense of where we are and how things work, it’s easier to organize our teams and get moving. This gives purpose to our work and confidence in the process with an eye towards the future.

For those interested in a further discussion of strategic thinking (and how the coronavirus affects the forest industry), click here to read a five-page white paper.

Managing Risk by Screening Out Trouble

My work as a researcher in forestry sometimes highlights ideas relevant to developing plans or managing risk in other industries. For example, it helps to have a simple screening and ranking process. Without a structured approach to ordering the world, the world will impose its views on us. 

The fact is some things are more important than others, some things are easily verifiable, and some things depend on others. We have “nice to have” and “need to have.” There are “necessary” conditions and “sufficient” conditions. Simple processes help us sort the mess and prioritize.

At Forisk, my research team applies simple screens each quarter to the wood bioenergy sector to sift out speculative projects. Typically, our analysis suggests one-third of these projects will fail. We’ve fielded disgruntled calls over the years on this, but back-testing has found that our screening, applied consistently and systematically for over a decade now, has been helpful. 

Our screen poses two answerable and generalizable questions. First, does the project rely on a proven technology? In other words, does this thing work? Second, has this project secured at least two of the necessary resources or agreements such as financing; air quality permits; engineering contracts; or supply agreements? In other words, is this thing moving forward and on schedule?

While we can always ask other questions, this approach has proved useful in systematically distinguishing probable from speculative projects, investments, and technologies. Simple screens don’t tell us everything, but they do tell us something that focuses the mind and reorders follow-up questions.

We all apply screens in our lives. Does he tell the truth? Does this house have three bathrooms? Does this car have a big enough trunk for my flux capacitor? The key is to apply these screens consistently, systematically and then revise based on back-testing performance over time. That’s how we learn and improve.

For those interested in a further discussion of screening risk or the wood bioenergy sector, click here to read a seven-page white paper.

The Math of Investing and Our Unease with Rational Thought

Professor Richard Thaler won this year’s Nobel Prize for Economics, in part, for research confirming that we (humans) believe we are smarter and more rational than we actually are. Asked how he plans to spend the $1.1 million prize money, Thaler replied, “I will try to spend it as irrationally as possible.” [Should he call, please let him know I stand ready to help.]

Reading Thaler’s research raises issues relevant to investing. We may believe we have superior insight into the value of an asset or the wisdom of a strategy, and that this belief in our own insight – as opposed to subjecting the insight to a suitable gauntlet of tests – gives license to act and a means to profit. This encourages us to overweight our assessment of values and market plays, while discounting the reality that hundreds or thousands of other (humans) are looking at the same data at the same time and coming to similar conclusions.

When too much capital chases too few assets, it creates its own momentum. And this momentum of the institutional conscious can lead to overvaluing assets. So when we prophylactically ask whether any asset is priced above or below its intrinsic values, we should assume the icy logic and rationality of Dr. Spock and look to the math.

Click here for a longer post that applies this thinking to timberland investments.

When Do We Overvalue Investments?

In 1990, Nobel Prize-winning economist Daniel Kahneman and two colleagues published a study documenting how we can “overvalue” things we already own (D. Kahneman, J. Knetsch and R. Thaler, “Experimental Tests of the Endowment Effect and the Coase Theorem,” The Journal of Political Economy, December 1990). This “endowment effect” applies to investors who may hold on to assets beyond their strategic relevance, failing to account for true opportunity costs, and missing out on opportunities to reallocate that capital to investments that better meet the needs of the portfolio.

Recent reporting in The Economist magazine also highlights the powerful incentives investors have to stand behind the original return assumptions for their investments (“Interest Rates and Investment Returns,” March 2, 2017). Beyond the resistance to accept a potential error, some make the case that low interest rates have reduced borrowing costs for firms, which increase opportunities for outsized returns in the future. In our view, this argument can strain efforts to support return expectations and hurdle rates, and reinforces the importance of firmly making the best investment decisions given our understanding of current values and opportunities.

When we consider investments, we must look forward. This may require us to adjust our thinking for probable nominal returns.

In forestry, for example, we often struggle with “sunk costs.” When evaluating the current value of our timberland investment against new investment opportunities, we must do so with ice in our veins and clear financial analysis on hand. We, first, ignore sunk costs and, second, evaluate forest investments based on their ability to generate income and returns moving forward.  The only time we have complete control over our portfolio is today.

Clear here for key questions to ask as applied to timberland investments.

Common Errors and Potential Approaches for Evaluating Investment Strategies

Understand how to understand and frame the current situation.  [That was not a Rumsfeldian typo.] Executives and investors make, or don’t make, decisions on how to allocate capital and other resources based on their understanding of the current situation.  On average, our team at Forisk supports over $1 billion in capital projects, transactions and plant construction in the timberland and forest products industry each year.  While everything may not look like a forestry situation or timber market, I have learned that few situations are that unique.  For example, common errors and sources of resistance to “scraping the ice off of the windshield” include:

  • Failing to consider the view from the other side of the table. In forestry, when we own something – when we buy land and grow trees – we tend to see things from that point of view.  And yet owning timberland is but one side of a two-sided equation.  What does a mill see?  When a forest products firm thinks about building a mill, what does it look for?  Understanding this helps us assess timberland values and forest management strategies.  Conclusions from this type of analysis and research are relative.  It’s a constant comparison of one market to another, of one region to another, GIVEN an assumption about the economy.  
  • Imposing rigid projections for the economy.  Nobody forecasts the economy well; it’s a hard place to create value. For capital budgeting and investment strategies in forestry, prioritize understanding how THIS local timber market or THAT local wood basket performs relative to every other given an assumption about the economy.  Massive economic growth?  “These timber markets are positioned to outperform those.” Brexit? “Those markets would be affected this way, and those timber markets that way.”  And so it goes.  
  • Forgetting to test opinions and data sources.  When thinking about information and the situation, consider the source.  Who is telling you this and where do they get their information?  Few people I know have a process for testing their own ideas and assumptions, or testing and thinking about the data and information they hear from others. 
  • Creating goals via fiat rather than by analysis. Pushing for stretch targets differs from disregarding the projections from your team and replacing them with a decree of what they should be.  I have heard too many times executives say their direct reports sandbag their budgets and expectations, and that they need to be pushed. Well who made them sandbaggers in the first place? (If that’s even true.)  Padding the numbers is a response to the organizational environment.  In most cases, it’s a culture that punishes missed numbers rather than risk taking.  Just understand what you have, why you have it, and how this lines up relative to what you actually want from your team, career and portfolio.

At the end of the day, we need to systematically aggregate the facts and organize them in ways that bring to the forefront an understanding of how things work. That means part of our responsibility and obligation is to develop a true sense of the current situation. Without that, it becomes difficult, if not impossible, to plan and strategize for the future. We must confirm the facts as best as possible given the time and resources available, get varying points of view on what they mean, think for ourselves what makes sense – is this operable? Doable? Actionable? Viable? – and if we remain unsatisfied with where we are, get back to getting more data and viewpoints.