Knox on fox in socks in box — Dr. Seuss, Fox in Socks (1965)
The sing-song early-reader book Fox in Socks was initially published in 1965 by children's book aficionado Dr. Seuss. Bearing his trademark nonsensical rhythm and rhyme, it appeals to our irrational love of structured chaos. I.e., the same basal needs that prompt us to collectively spend $200 million watching Arnold Schwartzenneger run around, blow things up, and save the day. Remarkably, said inanity would eventually translate into 21st century economics.
Perhaps Frank Knight predicted the connection. Knight (1885-1972) was a University of Chicago professor of economics, whose signature work Risk, Uncertainty, and Profit made the case that the concepts of risk and uncertainty should be differentiated. Risk referred to scenarios involving calculable probabilities, whereas uncertainty involved events in which probabilities could not be reliably assigned. His work advanced the principles of neoclassical economics, whereby supply and demand relate to rational behavior and the normal propensity to maximize efficiency and profitability.
Granted, he was a dork. But he was a smart dork, whose so-called "Chicago school of economics" later included prominent free-market advocates George Stigler and Milton Friedman. Yes, it's a stunner that a guy named Milton would grow up to be an economist.
Risk, reward, rationality and uncertainty are inexorably intertwined, with the events of the Great Recession laying bare the complicated relationships between supply and demand in conjunction with both rational and irrational behavior.
Fort Knox
As anyone above the age of six is aware, within Fort Knox is a massive quantity of gold. Situated about 35 miles southeast of Louisville, Kentucky, it contains approximately 147.3 million ounces of holdings. When imagining riches, inevitably one of the first thoughts that crosses the mind is having a large quantity of jewels and precious metals, diving into a heaping pile of gold coins and doing the backstroke like Daffy Duck in a Looney Tunes cartoon.
Increasingly, modern culture has promulgated the notion that riches can be obtained quickly. Movies and television feature it; state-sponsored lotteries and regulated casinos sell the promise of it. Not surprisingly, popular and inventive versions of get-rich-quick schemes popped up in the years before this past recession, including rampant day trading in the late 1990's/early 2000's, and later in the decade, excessive real estate speculation.
Combined with other factors, both sets of behavior ultimately resulted in disastrous market corrections. The relationship between risk and reward became horribly skewed by market irrationality. Supply and demand factors, by themselves, did not contain the unpredictability of irrational behavior in the short run. Ultimately, market forces eventually took hold, but in lieu of normal corrective actions, the markets experienced tumultuous, severe ones.
Chuck Knox
Chuck Knox was a long-time NFL head coach for the Los Angeles Rams, Buffalo Bills and Seattle Seahawks. His coaching career spanned two decades and featured eleven playoff appearances, including seven division championships.
Knox was pinned with the nickname "Ground Chuck" due to his trademark conservative offense, which featured a strong running game and cautious passing attack. As compared to the speculative, uncertainty-embracing risk-taker mentioned above, Knox was a certificate of deposit holder. Spectacular highs and crushing lows weren't part of the Knox playbook. As a result, probabilities could be assigned, as uncertainties were minimized.
Without question, Knox found success within his highly-structured, low-risk approach. However, many would argue his failure to reach the Super Bowl was due, in part, to his reluctance to take risk.
Hard knocks
Columnist/playwright George Ade coined the phrase "school of hard knocks", an idiomatic expression referring to life's lessons learned. Neither side of the risk continuum, practiced in the extreme, is devoid of potentially painful morals. The consequences of the riskiest extremes are well-documented, and yet even the most conservative position carries a price.
Opportunity cost is defined at Investopedia.com as "the cost of an alternative that must be forgone in order to pursue a certain action". When a choice is made, the what-if factor has an assignable cost component. Earning .1% on a passbook savings account equates to taking no risk, but essentially no reward. Likewise, carrying consignment products instead of inventory in a retail business diminishes risk, yet lower returns. The tradeoffs may or may not be acceptable to the individual investor or business.
Pot of gold pursuers incur speculative risk; the most conservative investors need factor in opportunity costs from forsaken potential gains.
Opportunity knocks
Risk-taking and risk-aversion can coexist successfully. Financial professionals espouse diversification to minimize risk while still theoretically providing acceptable returns. The degree of diversification recommended varies depending upon the individual's willingness to accept greater risk in trade for the potential of higher returns, the age of the investor, the inflation rate, liquidity and income needs, and other factors. Over time, the blend tends to become more conservative, as the need for capital preservation gradually outweighs the desire for greater gains.
No strategy is foolproof, and all carry imputed probabilities, uncertainties, and opportunity costs. Due to the potential for titanic explosions, significant risk-takers assume a higher profile, often with their results laid bare for the world to see. Inevitably, this incites guys named Frank and Milton to theorize over causality in long, boring papers.
Summary
Knox, Knox, knocks, knocks: four principles of economics interwoven within a contrived Dr. Seuss-like theme. The concepts, however, are very real. Each contain varying levels of risk and reward, and (assuming rational behavior), assignable probabilities. Irrationality — seemingly the mantra of the late 1990's through the real estate market crash to follow — altered the perception of the relationship between the two. On the other hand, the rational Chuck Knox approach mitigates the risk, but has a much higher potential opportunity cost: no Super Bowl for Chuck.
In the end, a diversified approach carries the greatest probability of balancing risk and reward satisfactorily. Let's face it: Frank and Milton have better things to do than theorizing about your reckless behavior. Swigging a healthy dose of Metamucil is probably one of them.
Sources:
- University of Chicago Library (accessed on 2/2/12)
- Library of Economics and Liberty (accessed on 2/2/12)
- University of Michigan (accessed on 2/2/12)
- Random House (accessed on 2/2/12)
Walter McLaughlin - I am a 47-year old commercial banker living in the Seattle area. I am an avid sports fan, but also greatly enjoy writing satirical, ...
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