Game of Thrones S8: A Zombie Primer In Portfolio Risk Management

“Game of Thrones” is back on the screen, for the 8th and last season. Proselytised fans around the world are flocking to learn the final fate of Cercei, Daeneris, Jon Snow, the Stark children and Tyrion Lannister in what has become the most popular series of all time. The final season starts where the previous one left off: A massive army of dead zombies is just days away from sweeping Westeros –a fantasy medieval Britain-like country- and turn its inhabitants into… well, more dead zombies. Many Westerosi leaders, however, opt to jockey for position rather than agree on a common defence, which would give them a chance to avoid spending eternity as dismembered flesh eating animated cadavers.

Now the “Army of the Dead” is not an unquantifiable or invisible risk. At the end of last season, a live (sic) specimen from that army was dragged across Westeros and presented before all would-be-kings. Yet, they remain too focused on their power struggle to acknowledge the real stakes. One would think that the decision is easy: a shot at being a King and risk eternal hell, or become a High Lord and possibly live? Apparently, a slim chance to the throne is worth disproportionate risk.

Real history is also littered with examples of risk miscalculations: Before Constantinople fell to the Ottomans, Byzantine citizens were too engaged in religious arguments, rather than planning the city defence. A few days later they were sold to slavery or perished during the sacking of the city. In 1986 Soviet leaders prioritised perception over risk management in Chernobyl, contaminating Europe for a generation. In the last days of Lehman Brothers, Dick Fuld, the CEO, was too engaged in wrecking a deal with Nomura which would see him pushed out, rather than try to save his company –and trillions of global wealth in the process.

Why do people, generals, presidents, CEOs or investors, miscalculate risk so much and so obviously? Two are the main culprits: Psychology and diverse risk definition.

Problem 1: Psychology

Daniel Kahnemann and Amos Tsversky’s work uncovered over 150 cognitive and emotional biases in decision making. The ones most responsible for catastrophic risk miscalculations would be:

Cognitive Dissonance: When someone is confronted with new information, the brain feels some uneasiness (dissonance). If that information directly contradicts the brain’s world perception, then dissonance encourages confirmation bias. The leaders of Westeros think of themselves as kings. Therefore any information that would compromise their identity is either deemed not credible, or the risk is downplayed. CEOs of big companies often think the same.

Optimism Bias: “This will not happen to me”. Queen Cercei believes that her mercenary army will protect her from the dead or dragons, despite all evidence to the contrary. Optimism bias is necessary when someone goes to war for example. No one thinks “I have a 30% probability of rotting in a jungle or a 50% probability of returning without a functioning limb”. Young men and women who register to fight imagine themselves at the head of a triumphant procession not as invalids. Investors often downplay risks the same way. They often ask “what is the return”, rather than “what is the risk I have to take to achieve X% return?”.

Overconfidence/Self Attribution Bias: The “Leader Risk”. If one’s bets have played out often enough to get them to power, they would attribute great powers to their decision making abilities. “If I got it right then, I will get it right now”. A successful referendum in 2014 prompted a second –less successful- for PM David Cameron. Risky investors and hedge fund managers whose excessive bets paid off, would be encouraged to take more excessive bets going forward, rather than acknowledge the role of randomness in their success.

Problem 2: Definition of risk

The second part of risk miscalculation, is that risk itself is differently defined for all actors. Back to Westeros. For Cercei to bet everything on a mercenary army dominating against zombies and dragons actually makes sense, insofar as she has committed so many crimes that she cannot possibly hope to live out her life in peace and comfort if not in complete control of her own destiny. “In the game of Thrones, you win or you die”. For Jon Snow, it makes perfect sense to give his crown up to save his people, he never really asked for it anyway.

In the financial world we broadly define risk as volatility, the deviation from a mean return. If, for example, I want 8% return per annum, it’s better to have 8% per year, rather than experiencing one year of -3% and another of +20%.  Why? Daniel Kahnneman’s Nobel Prize was on exactly that issue: he proved that we tend to experience losses more intensely than wins.

But volatility is not everyone’s enemy. For traders, it is their friend. A portfolio which bought most market dips this year in the US may have returned as much as 20%, almost twice the return of the S&P 500 – without the use of leverage which traders love.

Volatility should also not be the long term retail investor’s enemy either. If investors stick to their true horizon, at least 3-5 years, they should not worry for anything in the interim. Depending on how much one can afford to lose, volatility may or may not be an issue.

And the theory itself has holes: Stocks are not “normally distributed”, which in practice means that risk models don’t work in very volatile environments. Also, the theory assumes that investors, on average, get rewarded with more return for each unit of risk. The graph below, a simple risk-return profile of the FTSE 100 stocks (R2=10%) suggests that often investors are not compensated for risk in any linear way, even on a five year basis, or that they can be too compensated. The highest volatility stocks actually produced greater than expected returns, which means that volatility, in this case study, was a friend.

Source: Mazars Calculations

What is the conclusion for investors?

One: We should never judge risk in hindsight. People make decisions based on the data available, and sometimes, even if the outcome is not the desirable, they may have been the right decisions at the time.

Two: Risk is individualised. We don’t wish to doubt Harry Markowitz’s Nobel Winning reward/volatility model, which has been the bedrock of portfolio management for over 60 years, but as Bloomberg’s John Auther’s spent a month pointing out, the discussion of what risk is needs to be broader in range, deeper in thought and individualised for investors.

Three: Be glad we don’t live in medieval times. Even without dragons and armies of the dead, life with serfdom and without indoor plumbing was pretty miserable. Unless you were a Lord. Or a King. Or had Dragons.