The Circle of Sadness
One thing that a lot of people don’t know about me is that I cry during pretty much every Pixar film. In fact, I made the mistake of watching Up for the first time on a flight to Germany and was such a weepy mess just a few minutes in that the stoic Lufthansa flight attendants felt compelled to come check on me. I’m not sure why I’m sharing this other than this is the background you need to understand why one of the best ways to think about risk management comes from Inside Out.
If you don’t know the film, the premise is that all of us are run by competing emotions with distinct personalities inside our head with each of them “driving” at different times. When Joy’s in charge, for example, we’re happy. When Anger is, we’re mad.
The plot of the movie is that an 11-year-old girl moves from Minnesota to California and in doing so starts to be driven more and more by Sadness (which is what happens when one leaves the Midwest). Joy, however, doesn’t want to see that happen and does everything she can to stop Sadness from taking over, but in doing so sows chaos. It’s great entertainment.
One iconic scene is when Joy draws a circle around Sadness and says that her job is to make sure all of the sadness stays inside of it. And that’s precisely how to think about risk.
See, when you’re taking risk, whether business or operating or investment or duration or whatever, you’re not going to walk away unscathed 100% of the time. What’s more, that arguably shouldn’t even be a goal because if you’re always right, it probably means that you are not taking enough risk. But if you know that you are going to be wrong or unlucky, then what’s critical is to make sure when you are, the consequences don’t overwhelm you.
For example, if you have a portfolio of real estate, it probably all shouldn’t be on the beach in Miami because if you’re wrong about hurricane risk, then you’re going to have a real problem. Or if you have a handful of businesses, they probably shouldn’t be guaranteeing one another’s loans because if one goes down it’s going to take the rest of them with it. Or if you have operating funds and emergency funds, you might not keep them in the same account at the same bank, just in case. Because if that bank fails, you’d lose access to your emergency funds at exactly the time you need them.
The term for this in high finance is ring-fencing, but ring-fencing applies everywhere. It’s the deliberate practice of acknowledging that bad things happen and therefore organizing yourself in such a way that when they do, it’s not game over.
– By Tim Hanson