In March this year, internet searches that included the word ‘risk’ spiked to their highest in recorded history; almost double the prevailing intensity for the previous 10 years. Objectively, levels of economic, business, health and social risk have all undoubtedly increased since the COVID-19 outbreak. However, risk means different things to different people.
What does ‘risk’ actually mean? And do we have more to fear from these new risks themselves, or instead from the way that we choose to respond to them?
The Oxford Dictionary defines risk as ‘the possibility of something bad happening at some time in the future’. I suspect that most people would agree. But let’s unpack this. There are three elements:
(1) ‘possibility’ i.e. uncertainty,
(2) ‘something bad’ i.e. an adverse outcome, and
(3) ‘in the future’ i.e. not something immediate.
Uncertainty is at the centre of most assessments of risk. We don’t know the outcome, because we don’t have sufficient knowledge. Partly that is because anything ‘in the future’ has some degree of uncertainty. If we were certain that something bad was going to happen, then there would be no risk and we could create a clear plan or price. It is therefore lack of knowledge that underpins risk.
‘Something bad’ is more debatable. When most people think about risk, they are really thinking about the risk of loss. However, when investors consider risk, they typically mean something different. Risk to investors is essentially not knowing the outcome; the final result could be better or worse than expected, but either is a risk. For this reason, the degree of potential variance from a supposed outcome is the way that the risk of say a real estate investment is typically measured and expressed in its yield.
Investors address risk by holding diversified portfolios. When these are sufficiently large, the asset specific risks are removed as part of a pooled return. However, most people don’t appraise risk this way. On a personal level, you or I will:
(a) care much more about loss than variance,
(b) not appraise uncertainty in any scientific or mathematical way, and
(c) make judgements based on experience or heuristics.
The problem with this approach is that humans are flawed. The overlay of behavioural economics (the psychology of economic decision making) eats theoretical principles for breakfast. Relevant to this discussion, we are neurologically risk averse. By that I mean that most of us are hardwired to overexpress downside risks and to adopt overly cautious approaches as a response. This distorts the best collective outcome. It is precisely this irrationality that we may need to fear more than the risks themselves in the period ahead of us.
How does risk aversion create damage?
There are sometimes very good reasons to be risk averse. This may for instance stem from a need to be certain. If you have fixed liabilities to discharge, with penal outcomes from not being able to do so, then you may be willing to sacrifice some benefit to avoid this risk. This might for instance be the risk of not being able to pay your mortgage for risk of losing your home – so you take a lower paid job with predictable income. It might mean not being able to retire unless your pension pot is sufficient – in which case you shift towards lower yielding cash investments in the period leading to retirement.
It may also be because the damage arising from the risk is so severe, that any degree of risk is not tolerated. For instance, you may not be willing to go on public transport for fear of catching a deadly virus. Is this rational? Much depends on the circumstances.
Firstly, one needs to consider the probability of the risk arising. At the time of writing there are ~750 daily reported new cases of COVID-19 in the UK. Grossing this up for asymptomatic / non reported cases, let’s say that the real figure is 3,750 cases. The mathematical chance of you contracting the virus today in a population of ~66m is therefore about 0.01%. Very low. If you’re not working in health care, or a resident of a care home this risk falls further.
Meanwhile, the ratio of deaths to confirmed cases in the UK is ~15%. Pretty high. Hence there is a very low risk of catching something with potentially very severe consequences. In response to this most of us in the UK are taking a very risk averse approach. However, particularly those under 30 (for whom the mortality risk is very much diminished) are likely to be acting mathematically irrationally by staying indoors, not using public transport, or not going back into the office.
This is the extreme, but risk aversion is also taking other forms. For example, at the start of the outbreak, people were very concerned about not having enough toilet roll. The spike in demand meant that toilet roll traded online at multiples of normal prices. The risk of not being able to secure it was misplaced, and the consequences of not being able to do so (whilst unpleasant!) were not life threatening. On the other side of this equation, hotel room bookings have fallen through the floor; perhaps due to health concerns. This again feels irrational based on the incidence levels, leading to good deals for customers and losses for operators.
All of these things have real consequences both in the short and long term. In the short term, pricing is distorted. In the longer term, risk aversion is likely to lead to economic damage, and potentially societal change. We know that when the economy performs less well, consumer and financial risk aversion increases. To the extent that risk aversion is overexpressed, it will supress growth and ironically create greater risk of loss. We also know that the most significant economic impact of previous pandemics has stemmed not from mortality or from inherent output issues, but from risk aversion. When people don’t go to work, don’t go shopping, and sit on their cash the whole economy suffers.
It’s not just consumers. Corporate risk aversion also increases in economic depressions. Businesses should be more rational about risk; however, this often falls down for two reasons. For businesses the comparable to death is business failure. Once in administration there are no second chances or the opportunity of better returns next year. A second reason is that businesses are run by people with the same human failings. No one wants to be labelled as the Chief Exec of a failed business, and shareholders won’t be that interested in an ex-post justification of the risks that were taken. For this reason, businesses will often overexpress the downside risk, and take actions to prevent it; worrying less about the foregone profit that results from these actions.
How might this impact on the real estate industry?
The real estate industry is pro-cyclical and suffers when the economy suffers. Risk aversion is not in our interests in a generalised sense. There are also specific risks. The longer that people might perhaps irrationally choose not to use offices and retail units to work and shop, the greater the risk that these behaviours become hardwired with longer term consequences. But this perhaps oversimplifies things. As with all periods of elevated risk, smart people and businesses succeed.
Entrepreneurs (who can defray risk onto others) and businesses that are capable of taking a longer view or rationalising short term risk will find mispricing opportunities. There are a number of sectors that have suddenly increased in relative attractiveness from a structural perspective. However, there will be a greater number of buyers chasing fewer of these opportunities. The question remains to what extent buyers will overpay based on an irrational degree of risk aversion. At the other end, some assets subject to negative trends might suddenly look well priced, particularly where sellers have few options.
Another (awful) way of avoiding risk is to do nothing. Many conflate the act of doing nothing with taking no risk. They are not the same. Choosing to do nothing is an implicit affirmation of the status quo, which can carry significant risk. This includes keeping your current portfolio mix, holding back on repositioning plays and pulling out of transactions. As value drivers shift quickly in many directions, it feels difficult to arrive at the conclusion that the future will resemble the past. As Mark Zuckerberg once said, ‘The biggest risk is not taking any risk. In a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking risks.’
There will be opportunities to do things differently arising from this period of change. The biggest winners as ever will be the ones who are willing to take a different path and look through the short-term risks.