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Given the events of the past month, the topic of resilience seems particularly timely. Recently I rec'd a copy of a paper published by Sander E. van der Leeuw and Chr. Aschan Leygonie entitled
which was presented at the workshop on "System shocks and system resilience" held in Abisko, Sweden, May 22-26, 2000.

The concept of resilience originally comes from physics, where it is defined as a value that characterises a material's resistance to shock. Subsequently it was adopted by ecologists, initially in the same sense as in physics. Thus, applied to ecosystems, resilience defines their capacity to resist a perturbation or to return to equilibrium after having been subjected to a shock. In this context, resilience expresses the notion of a system's stability around a point of equilibrium.
In 1973, Holling proposes a new significance for the term. It is no longer based on the traditional homeostatic systems approach, because it supposes the presence of a certain number of basins of attraction or domains of equilibrium rather than a single, fixed, equilibrium:
[Resilience is] the capacity of a system to absorb and utilise or even benefit from perturbations and changes that attain it, and so to persist without a qualitative change in the system's structure.

Thus a perturbation of considerable magnitude is necessary to trigger a qualitative change in a highly resilient system. In this definition, Holling distinguishes very clearly between stability and resilience; the first indicating a system's capacity to return to equilibrium, and the second the fact that the system does not lose its internal structure in a period of perturbation. A system can be highly resilient and yet fluctuate widely, i.e. have low stability. A resilient system is able to
incorporate changes in its way of functioning without changing qualitatively. It keeps the properties that characterise it before, during, and after perturbation. Another essential distinction between this perspective and the homeostatic systems approach concerns the way in which uncertainties and risks are taken into account in a system.
Traditionally, human societies have searched for means to reduce uncertainties and risks by increasing control of the physical environment in particular. For example, we generally choose to
protect ourselves from secular events (for example by constructing dikes against flooding), and we justify this with reference to medium-term risks, while we prefer to consider the occurrence of millenary events as uncertainties which are too difficult to take into account. Those responsible have preferred to ignore such uncertainties, because they are incalculable, and to turn their attention instead to the risks that can be estimated, in particular to those that occur frequently. But
from the point of view argued here, rare occurrences and the uncertainties they imply are considered impossible to ignore or control. It is thus necessary to take them into account as an integral part of the system, while of course at the same time attempting to reduce their negative effects.

Thus there are two closely related aspects of resilience which we must consider. The first concerns the behaviour of a system, due to the structure of its attributes and the interactions between them, due to voluntary management or depending both on the inherent characteristics of the system and on human effort. The other aspect concerns the perception of perturbations and change, and notably of unexpected or even unforeseeable future events.

In regard to resilience, the types of risk we are concerned with all tend to have a low probability of occurrence, placing them into the realm of low-probability but high-consequence risks. We know from experience that low-probability-high-consequence risks are very, very difficult to manage. The four conventional risk management strategies in finance are:

1. Diversification.

2. Insurance.

3. Pre-loss Hedging

4. Post-loss reinvestment with reserves

All of these strategies can be used to promote resilience but the effectiveness of each strategy is highly dependent upon the nature of what is being protected and the type of system disturbance.

For example, high consequence but low-probability risks can affect many asset classes simultaneously rendering conventional risk management through diversification ineffective.

Likewise, Insurance for low-probability-high-consequence events historically has been very expensive because probabilities are difficult if not impossible to define, and consequences are hard to predict with any certainty. (Hence the higher implied volatility normally seen for long term equity options)

Hedging strategies always involve tradeoffs and can be expensive to maintain. It is impossible to hedge against every risk factor. For example,one could make a point of being slightly overweight the energy sector to hedge against the possible effects of an energy shock, but this exposes that portfolio to possibly even greater risk from economic recession and plunging oil prices.

Post-loss reinvestment is a useful strategy but requires adequate reserves pre-loss or a systematic program to build reserves once an adverse development is identified. Post-loss reinvestment also requires substantial judgment with regard to the timing of reinvestment.

The structure of a system and the interactions of the pieces within it control the capacity of a system to be resilient and competitive. Rigid interactions of the main components in a system can block potential adaptation to a new situation brought on by unanticipated changes. Specialization is generally considered as a negative for a system's resilience, as specialization tends to increase the system's vulnerability to disturbances, and magnifies feedback. However specialization can lead to more success against competition. Creating structures that promote adaptability in a system with a low level of diversification are the key to forging a balance between resilience and competitiveness.

In the end, I suspect that most individual portfolio managers should opt for a combination of adequate, but not excessive diversification, combined with a program to constantly build or maintain adequate reserves. Such a program of investment concentration while simultaneously maintaining adequate reserves is one way to effectively strike a balance between competitive position and resilience.

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