Why Your Risk Calculations Are Lying to You
Why Relying on Beta and Volatility Is Setting You Up for Failure
The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one.
The commonest kind of trouble is that it is nearly reasonable, but not quite.
Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.
G.K. Chesterton
This quote describes how the world seems logical and predictable, but just not quite. This gives us the illusion that we can fully understand and control risks through models and numbers, as investors often attempt with volatility indicators or betas. However, the real challenge lies in the unexpected—the hidden chaos that always lurks beneath the surface and can't be captured in numbers.
It’s funny, really, because two years ago, I never thought I'd be writing about risk. So here we are—it’s kind of ironic. I've never been afraid of taking risks. Not in my investments, not in life. Risks? Boring. Something for whimps.
But yeah, that was before I got burned a couple of times in the markets (looking at you, Nio, and more recently, Alfen...). Those moments really made me think. And then I stumbled upon a particular author (yep, I’ll mention him later). He got me thinking about something I’d always ignored: the true value of risk. And here I am, trying to figure out why something I used to find ‘boring’ now feels like one of the most important aspects of investing.
This blog post is my attempt to make sense of the whole risk thing. It's definitely not a final answer—more like a start. And if you're just as curious as I am about where this will lead, go ahead and subscribe. There we go, self-promotion out of the way. Let’s fucking go!
Ignorance, Uncertainty, and the True Nature of Risk
Let’s start by defining what risk actually is. A lot of people assume that risk equals volatility. But two icons in the field of risk management, Howard Marks and Warren Buffett, would disagree. Marks points out that "beta" (an indicator of volatility) was created by academics to make risk measurable. Volatility can be an indicator, sure, but it's not inseparable from risk.
Marks has a different definition of risk. He argues that risk stems from ignorance and uncertainty. When you invest in a company, it’s almost impossible to predict what will happen in the future because there are multiple scenarios that could play out. The uncertainty about which scenario will happen—that’s the real risk.
"Risk is the possibility that from the range of uncertain outcomes, an unfavorable one will materialize"
Howard Marks
Why Most People Get Risk Wrong (And What You Need to Know)
I’m an avid reader of various blogs here on SubStack, and I have to admit that I often come across things that are better than what I write myself. But one thing that really stands out to me is the optimism in many deep dives. Personally, I see a few reasons for this.
The first reason is the Sunk Cost Fallacy. The sunk cost fallacy is the tendency to stick with a decision or project because of the time, money, or effort that has already been invested, even when it’s no longer rational. There’s nothing shittier than spending weeks analyzing a company only to conclude that it’s just not worth it.
Second, there’s the Dunning-Kruger effect. AlphaPicks just published a very interesting article on this, which you can check out via this link, but let me give you a brief summary here. This effect describes how people with little knowledge or skills in a certain area tend to overestimate their competence, while those with a lot of knowledge or skills are more likely to underestimate themselves. This happens because beginners often don’t have enough insight to recognize their own mistakes, while experts are more aware of the complexities involved. Now, I’m not saying that all authors on Substack are amateurs, but investors are often advanced in valuing stocks and tend to spread themselves across different sectors to "diversify." The problem is that it's impossible to become an expert in ten different sectors. Your knowledge of, say, the real estate sector is never going to be as sharp as that of someone who’s dedicated their entire career to it. As a result, investors often lack the expertise needed to properly assess risk.
And then there’s that one author from the intro: Nassim Nicholas Taleb. The first time I heard about him was in the podcast "Jong Beleggen, de podcast." To be honest, I wasn’t impressed right away. Not because the podcast was bad—quite the opposite, I’m a big fan—but Taleb came across as a total pessimist. A year or two or three later, and after reading "Fooled by Randomness," I realized I had it completely wrong. He was right, and I was the one being naive.
Taleb, like Howard Marks, makes a good point when he says that our financial models simply can’t capture all the risks. Especially when it comes to Black Swan Events: those rare, unpredictable events that turn everything upside down. Marks and Taleb argue that we often don’t pay enough attention to less likely scenarios, convincing ourselves that these risks can be ignored and that they won't materialize.
Let me give you an example: imagine there’s a 10% chance that you’ll face unexpected expenses that you can’t immediately cover. Many people think, “Well, that probably won’t happen to me,” and choose not to set up an emergency fund. Most of the time, they’re fine. But you don’t want to be the person who ends up in trouble because an unexpected bill arrives that you simply can’t pay. This is exactly the type of situation Marks is talking about—and one that we all tend to overlook way too easily.
Risk and Reward: Finding the Balance
Now we come to the part that might be the most valuable for you as a reader: what can you do to manage risk? It might not surprise you that I’m pulling out another fantastic quote from Howard Marks, but it perfectly captures what, in my opinion, needs to be done:
“Risk is something to be managed and controlled, not avoided”
Howard Marks
Risk is unavoidable when investing, simply because the future is uncertain and, as a species, humans are notoriously bad at forecasting. So, there will always be uncertainty and risk. As for the forecasting, don’t waste too much time on analysts and macroeconomic predictions. I don't know of any report from 2019 that factored in a global pandemic. Personally, I see these reports more as entertainment that needs to be taken with a grain of salt rather than a reliable source of information.
According to the risk gods (Taleb, Marks, and Buffett), one thing you definitely shouldn't do is try to quantify risks. Forget the betas and all those fancy metrics—what you really need are the "subjective" opinions of experts on the topic, the sector, or the company. Despite their subjectivity, these opinions often come closer to reality than a beta that merely measures volatility.
When it comes to valuation, it can be useful to create a DCF (Discounted Cash Flow) analysis—not with a single point estimate, but with a range of potential outcomes. This allows you to factor in the worst-case scenarios and better understand how much you could lose if everything goes wrong. By doing this, you'll also spend more time considering the negative aspects of the stock and the impact they could have.
Lastly, I encourage you to take your own biases into account. There are many more biases beyond the sunk cost fallacy and the Dunning-Kruger effect. Knowing yourself is a prerequisite if you want to excel in investing—and, honestly, in life as well. And knowing what you don’t know is more useful than being brilliant.
Conclusion
The real trouble with risk is that it isn’t fully measurable, just like the world itself isn’t fully logical or predictable. We tend to fool ourselves into thinking we can capture risk with numbers and models, but as both Chesterton and the “risk gods” remind us, life—and investing—is far messier. True risk management is about embracing the uncertainty that cannot be quantified, preparing for the unexpected, and recognizing our own biases.
The key isn’t to avoid risk, but to understand it beyond the spreadsheets and metrics. It’s about balancing the logical with the unpredictable, seeking expert insights, and embracing a range of possible outcomes rather than relying on a single "safe" calculation. If we can do this—acknowledging both the limits of our knowledge and the unpredictable nature of the world—we can move towards a smarter and more resilient way of handling risk, both in investing and in life itself.
This is just the beginning of my exploration into risk and how to truly understand it. In the future, I plan to dive deeper into topics like how to build an effective margin of safety, navigating Black Swan events, and developing a resilient mindset in uncertain times. I also want to look at the role of psychology in investment decisions—such as emotional biases and overconfidence—and how to learn from historical market crashes to better prepare for future ones. If you're interested in this journey of digging beneath the surface and questioning conventional wisdom, make sure to stick around. We're only scratching the surface of what it means to understand risk.