Principles of Risk Management

Dan Amos, the CEO and Chairman of Aflac Insurance once said that the three principles of risk management are:

1. Don’t risk a lot for a little

2. Don’t risk more than you can afford to lose

3. Consider the odds

Insurance is known as an endlessly complex industry. Yet these rules are so simple. Anyone can understand them but the tendencies of human nature make them difficult to follow. Especially when they need to be heeded most.

Here are three stories about people who should have been most impervious to breaking these rules of risk management yet broke them anyway.

Bunker Hunt was the heir to one of the largest oil fortunes the world has ever seen. His father, HL Hunt, was the quintessential Texas oil man. Known to be a risk taker, in a stroke of remarkable good fortune he secured the rights to East Texas oil lands for $1M. These lands happened to sit right on top of one of the largest pools of oil in the United States, giving birth to the Hunt Oil Company.

The elder Hunt parlayed his massive East Texas oil fortune into other profitable businesses as well, discovering oil in Libya, and then diversifying his fortune into publishing and food production. His net worth was estimated by Forbes to fall within the range of $400M - $700M, making him one of the 10 richest people in the world in 1957.

Bunker was the heir to a hefty portion of his father’s fortune and in 1970, the United States was struggling with rampant inflation. Government spending and low-interest rates caused the economy to overheat and prices skyrocketed. Bunker believed that the only safe, inflation-resistant investment was silver as humans had ascribed value to this commodity for centuries, long before fiat currencies were developed and subsequently manipulated by central banks.

Hunt’s inspiration for this scheme in the silver market was inspired by a book called Silver Profits in the Seventies, by a man named Jerome A. Smith (basically the Peter Schiff or Anthony Pompliano of the 70’s). In his book, Smith made an argument that is very prevalent today “the world faced an imminent economic and political collapse, and that the only safe hedge was gold or silver. He urged wealthy investors to buy both and store them in Switzerland - just in case Russia invaded the United States.”

So in 1974 as only one with his wealth could, Bunker began amassing silver contracts. By the time his initial buying spree was over, the Hunts owned 9% of the world’s silver, more than any government at the time. 

Unfortunately for Bunker, his thesis didn’t play out in the short run and the price of silver began to sag. So in hopes of propping up the price, the oil heir went to meet with Middle Eastern royalty including the Shah of Iran and the King of Saudi Arabia to convince them to join his buying cartel.

The Shah refused and the king of Saudi Arabia was assassinated so Bunker was left to find another mechanism for propping up the price of silver. Not easily deterred, the Hunts resorted to one of their partially owned, publicly traded companies, Great Western Sugar. Through Great Western, they continued their buying spree and by 1978 the family owned an even greater sum of silver.

As author Bryan Burrough wrote “The Hunts could have sold out then and realized a few hundred million dollars in profit. But like Clint Murchison Jr., doubling or even tripling his money bored Bunker. He wanted a true home run, the more intricately mastered the better.”

Still not satisfied with their purchasing power, the Hunts then went back to the Saudis and successfully formed a silver-buying cartel of massive wealth. By 1979 the Hunts controlled most of the silver in the Comex warehouse and a significant portion of the silver possessed by the Chicago Board of Trade.

This concentrated buying power drove the price of silver higher, much to the delight of Bunker and his Saudi allies. Adding fuel to the fire, short sellers (people who borrowed a silver contract, sold it, then hoped for the price to go down in an attempt to buy it back and return it to the lender for a profit) were being short-squeezed. A short squeeze is when a short seller is forced by the lender to buy back the borrowed shares they sold on the open market.

Similar to the GameStop saga of 2020, more Middle Eastern investors began pouring into the US silver market, recognizing that the more the price of silver went up, the more short sellers would be forced to buy to cover their loss driving the price of the underlying asset still higher.

In a bout of pure desperation, the Commodities Exchange (the regulatory body responsible for the commodities market) made an unprecedented decision. They halted all purchasing on the exchange, and only allowed the sale of silver. 

This prevention of buying activity caused the price of silver to fall inflicting much financial pain on Hunt and other owners of silver. Hunt protested loudly against the Commodities Exchange knowing that if he unwound the massive stash of silver he owned, it would cause the market to plummet.

To make matters worse, Hunt’s silver purchases were largely made on margin, meaning he borrowed a significant portion of money to finance these transactions. This was all well and good as long as the price of silver was rising. But once his silver, the collateral that underlay these loans, began to fall in value lenders got nervous. Soon Bunker was being ordered by lenders to sell his silver to meet his loan obligations. And predictably his forced sales plummeted the price of silver.

After a federal investigation, Bunker and his brother Herbert were charged with market manipulation and forced to pay a $130M fine to Minpeco S.A. a Peruvian commodities company. Despite the massive losses incurred, the brothers managed to survive their foray into the silver market.

But shortly after the silver market crash, the price of oil began to drop, hurting the profitability of Hunt’s oil businesses. This was the final straw for Herbert and Bunker. In 1987 they filed for Chapter 11 bankruptcy, in one of the greatest destructions of a family fortune ever the Hunts decimated $5B in a mere seven years.

Bunker had everything to lose and nothing to gain financially. If his fortune doubled it wouldn’t have changed his lifestyle. He already owned the largest collection of racehorses in the world, owned sprawling Texas ranches, and regularly traversed the globe in his private jet.

Bunker offers some important lessons about human nature.

1) An increase in your net worth feels better than a large net worth that is stagnant.

2) Being born to a man who assembled one of the largest fortunes in history makes all of your feats pale in comparison. You may take great, needless, risks trying to live up to the accomplishments of your forefathers.

3) Humans favor complexity over simplicity when it comes to money because it appears smarter. Many would rather attempt to get rich doing an “Iron Condor” option strategy than consistently investing in the S&P 500 even though the latter has a far better track record than the former. The Hunts preferred to get rich off an international commodities scheme rather than manage their oil businesses with prudence because the former option was sexier than the latter.

Risk is not restricted to the world of dollars and cents. There are things of value that you can’t accurately measure at any given moment that are still of incredible worth. But just like money, these things can be risked as well.

Tony Robbins is a motivational speaker unlike most. While many motivational speakers are viewed with similar esteem as a snake oil salesman, Robbins seems to be the one exception. My impression is that people really like Tony Robbins and find his work valuable.

By almost any measure Tony Robbins is successful. He’s sold millions of books, given thousands of well-attended speeches, developed successful television shows, and coached the likes of Bill Clinton, Hugh Jackman, and Pitbull. In the world of gurus, he is one of the few who is well-regarded in the mainstream.

So I found myself scratching my head when I read this piece from Nick Maggiulli reviewing Robbin’s new book about personal finance. The book proclaims to be a “tell-all” about the world of alternative investments including venture, private equity, and private credit.

Robbin’s pitch in the book is that the little guy can’t get ahead in this world because the big guys are putting up barriers to exclude them from mouth-watering returns. And luckily Tony has a “solution”. By investing with Robbin’s investment group he claims you can gain access to these exclusive opportunities and in doing so join the new rich.

Unfortunately, the facts don’t bear out Robbin’s point. Holding low-cost index funds outperforms the vast majority of actively managed funds, especially after accounting for fees paid to active fund managers. Robins knows that to get rich you need to run a fund where you can charge exorbitant fees, not invest in a fund where you pay exorbitant fees and that is why he recommends subscribing to the fund he owns, CAZ Investments.

And to make matters worse Robbins went on Chirs Cuomo’s show and announced that all profits from the book would go to his favorite charity cause. The irony here is that the profits Tony stands to make from book sales pale in comparison to the fees he would charge new investors who join his fund after reading his book. So not only is Robbins profiting from funneling people into an investment vehicle that will not serve the purpose he claims, he is doing so under the guise of being generous.

Tony didn’t risk much money on this deal. But he still risked more than he could afford to lose.

His reputation will be sullied in the circles of the financially literate who read his book. And now his reputation, which in some ways was more valuable than his $600M fortune, will be irreparably damaged.

I’ve given much thought to why Tony would do this. Why would he break Amos’ second rule of risk management and risk more than he could afford to lose?

The conclusion I’ve come to relates to a Charlie Munger quote “The world is not driven by greed. It’s driven by envy.”

Robbins may be worth $600M but he hangs out with billionaires. His friends include Ray Dalio ($15.4B), Oprah Winfrey ($2.8B), Robert Smith ($9.2B), and Marc Benioff ($10.3B). His fortune pales in comparison to those of his friends. So Robbins, who is rich by any metric other than the one he is likely using, decided to employ this scheme to boost his net worth into the billionaire echelon.

Charlie Munger has another line that fits well for this story “Remember that reputation and integrity are your most valuable assets - and can be lost in a heartbeat.”

Sometimes the largest risk someone takes isn’t in a moment of action but in a moment of inaction.

 After the advent of the computer in the 1940’s the President of IBM, Thomas Watson, proclaimed “I think there is a world market for about five computers.”

The prediction was ridiculous in retrospect but understandable at the time. IBM’s core business in the early 20th century was producing tabulating machines, machines that summarized information and stored it on punch cards. To a man whose business success was predicated on the prominence of this mechanical technology the birth of new electronic machines was likely one he did not want to contemplate and therefore assigned little likelihood to.

Though Watson passed away in the 1950’s his legacy likely persisted through the company’s culture as IBM was not at the forefront of the dawn of the personal computer despite their financial advantage over newcomers like Apple and Microsoft.

Watson is such a stark reminder that even when we have the best available information and are sitting front seat to the activities we are supposed to predict, it is hard for people to extrapolate events far into the future. It is difficult to calculate the odds of something happening when our livelihoods are at stake. That’s why Amos’ third law of risk management, “consider the odds” can be so hard to execute.

“Lately in a wreck of a California ship, one of the passengers fastened a belt about him with two hundred pounds of gold in it, with which he was found afterward at the bottom. Now, as he was sinking - had he the gold? Or the gold him?” - John Ruskin, Unto This Last

When it comes to matters of money, the mind is often influenced by greed, fear, and pride in ways that cause what we consider in retrospect stupid behavior.

So while these principles of risk management seem simple, they can be quite hard in practice.

It’s easy to risk a lot for a little when we derive pleasure from the change in our net worth, not the magnitude.

It’s easy to risk more than you can afford when envy drives the world.

It’s easy to miscalculate the odds when the likelihood of an event is uncomfortable to contemplate.

It’s important to heed these principles but it’s maybe just as important to recognize how easy it is to stray from these principles.