Why do people jump off cliffs in wing suits? What drags war reporters back to conflict zones? Why do test pilots choose to put aircrafts into stalls and spins? In short, what drives people to push the limits of machines, organizations and even themselves? And, better yet, how do these risk takers — often called “edgeworkers” because they operate right on the edge of life and death, order and chaos, sanity and insanity — maximize their chance of not dying? These are questions to which I’ve been increasingly searching for answers. Am I planning to paddle out at Mavericks this winter, you ask? Nah. But I am interested in how communities of extreme risk takers emerge and, crucially, how they survive. Let me explain why.
Equity markets are at all-time highs. Interest rates are at 30-year lows. Private market valuations are rich. Even with a few crises mixed in, markets have delivered autopilot returns that would meet most policy benchmarks over the past few decades. Institutional investors have had good years. But will this last? Will markets keep delivering? Will institutional investors have to look beyond betas and instead call upon alpha generators to get them up to the return levels they’ll need in the decades to come? As a close adviser to a handful of Giants, I hear these sorts of questions almost on a daily basis.
Many investors are paring equity exposures and are looking for innovative things that can provide the returns they need. In simplest terms, this means these organizations are going to have to take more risk: investment risk, career risk, peer risk, benchmark risk and so on. It’s inevitable. In a low-return environment, policy benchmarks won’t be met without higher levels of risk driving higher returns. Given this, I’m very interested in better understanding how we can help these funds build effective risk cultures; I want to encourage smart and sophisticated risk-taking in the context of well-articulated governance and risk budget.
To some it may sound odd that I would actively encourage these beneficial investment organizations to think about how they can build risk cultures. But I think it’s natural, as institutional investors are little more than professional risk takers to start with. They assess, mitigate, manage and trade investment risks. Investors need to take risks to do their jobs. Risk is the oxygen that gives life to financial markets. It’s the currency upon which all assets are traded.
But it’s not enough to just take risks; it has to be done in a calculated way. A big lesson from the subprime financial crisis was that many investors didn’t understand the risks they had taken. If these investors were edgeworkers, they’d be dead. So what can we learn about edgework to help these investors maximize their chances of success?
There are obviously many papers and surveys on behavioral finance, but I haven’t seen any articles that have applied the sociology of extreme risk-taking to the world of investment. And that’s a shame, because I have a hunch these extreme risk communities offer some unique insights for institutional investors. With this in mind, I’d like to refer you to a wonderful paper from 1990 by Stephen Lyng entitled, Edgework: A Social Psychological Analysis of Voluntary Risk Taking. While Lyng's paper was written for a different audience, it offers some interesting insights for investors developing an effective risk culture. In particular:
- "Edgework involves planning, purposiveness, flexible action and concentration. Skydivers spend far more time preparing for a jump than actually jumping." Translation: Investors need to develop procedures, processes, delegations, triggers and so on to help guide investment decision-making in challenging times.
- "Edgeworkers must be flexible enough to innovate an on-the-spot strategy for maintaining control over the situation." Translation: Investment organizations should avoid rigidity and silos and engender flexibility to move, organizationally, to where the opportunities are located.
- "In the completely novel circumstances of a true edgework situation, the individual can respond appropriately only by absorbing as much information as possible about the environment." Translation: Investors should seek to collect as much local information and knowledge as possible.
- “Edgework is about maintaining control over your mind in chaotic situations that most people would regard as utterly uncontrollable. The best are not frozen with fear but instead have an ability to zero in on what’s critical for survival and success and execute.” Translation: Human resources are critical to succeeding out on the edge. Also, a delegation of authorities that pushes power to the edge is important for empowering people in chaotic situations.
- Lyng's paper also offers some useful insights into how a risk-taking culture can lead funds astray: “When factors traditionally associated with skill are introduced to chance settings, actors develop the ‘illusion of control’ — that is, they behave as if they could exercise control over events that are actually chance determined... The greatest satisfaction or feeling of competence would therefore result from being able to control the seemingly uncontrollable...” Translation: Investors will have massive and unwarranted egos. Get used to this, and make sure you're looking over their shoulders at all times.
Ironically, it is the illusion of control that may actually lead to edgeworkers' success! Edgeworkers are able to control fear, focus attention and so forth thanks to their confidence; these abilities facilitate survival out on the edge. In a way, the fact that control is a fallacy is irrelevant; the edgeworker with the right stuff will be better out on that edge than somebody that is less experienced. In other words, broken clocks are right twice a day. This gives the clocks confidence, which makes them better in certain ways.
Anyway, I’m going to keep digging around the sociology of risk-taking to see if there are more lessons that can be applied to institutional investors. If, as we expect, these Giants are going to be asked to take higher risks in the decade ahead, this work may be important in helping them avoid cratering. If you have any good sources, hit me up.
