The Law of Risk and Light
“In the country of the blind, the one-eyed man is king.”
IT’S WIDELY REPORTED that markets are made because partici-
pants have different views of the opportunities in the market. For every
transaction, there may be an agreement on price but also an inevitable
complete disagreement on the direction of the next move in price. One
source for these differing opinions is the differing views of risk held by
various market participants. In this article, I’ll take a look at five com-
mon perspectives on risk and see how they affect not just each partici-
pant’s own choices but everyone else’s choices, as well.
Five Common Views of Risk
1. EYES SHUT—Some risk-takers firmly believe that real rewards come only
to those who take risks
blindly; they think that
caution, preparation and
analysis will generally
result in avoiding those
opportunities that have
the best payoffs. Many
share this eyes-shut view.
They are often the visionaries who stick to their
dream in the face of all
the naysayers. Are these
people phenomenally talented, or just lucky? Even
if the eyes-shut entrepreneurs follow completely
random strategies, one
out of 100 might be wildly successful. That one will be celebrated
in the press, while the 99 losers are
quickly forgotten. Perhaps some of these
individuals are indeed transcendentally
talented, but I will proceed under the
assumption that there are too few such
supermen to worry about.
2. QUICK LOOK—These risk-takers apply an approach that is tried and true,
often based on practical rules of thumb.
If the situation is familiar, they immediately turn to their usual method of risk
selection. Unfamiliar risks are rejected,
generally without further thought or
analysis. The reward for the quick-look
view of risk is often relatively low. But
the risk is generally low, as well.
3. ONE-EYED—This perspective adopts
a single specific quantitative mea-
sure of risk. The two most common
examples are volatility and ruin prob-
ability. Defining risk as volatility is the
basis for modern portfolio theory, the
Black-Scholes-Merton model and pric-
ing methods based on risk margin as a
function of standard deviation. The ruin
theory (or cost of risk capital) approach
defines risk (or capital) as a function of
the loss potential in an extremely remote
4. TWO-EYED—In this blended approach,
the risk-taker seeks compensation for
both volatility and the possibility of ruin—or at least seeks to avoid extremes of
one or the other.
5. MULTIDIMENSIONAL—Risk managers with a multidimensional view
consider volatility, ruin and everything
in between. In addition, they consider
risk factors such as parameter risk, correlation, market cycles, liquidity and
execution risk. They include not only
types of risk that are readily quantifiable
but also those that may be extremely difficult to measure.
The choice of which
view of risk is the best
isn’t immediately obvious.
There are several strengths
and weaknesses to each
approach, as summarized
in Table 1.
Each risk view will tend
to drive the firm’s risk portfolio in a certain direction.
Most important, risks that
are “in the light” (i.e., recognized by the prevailing
risk view) will be managed,
mitigated or avoided, while
risks that remain “in the
dark” (i.e., unrecognized
by the prevailing risk view)
will tend to accumulate, generally without adequate compensation. This can be
The Law of Risk and Light
Risks in the light shrink, risks in the ■
Return for risks in the light shrinks ■
faster than the risk;
Return for risks in the dark doesn’t ■
grow as fast as the risk.
A closely related law is: