“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. Gradually and then suddenly.”

– Ernest Hemingway,
The Sun Also Rises

The above dialogue, often presumed to be the pithy observation of an aristocratic drunk, actually recalls Ernest Hemingway’s personal financial circumstances around the time he wrote his breakout novel. It merits our attention because the decisions that lead to those circumstances illustrate a principle of risk-management used by all of the worlds most successful investors from Warren Buffett to George Soros and beyond.

The principle is an investment formula known as The Kelly Criterion. Simply put, it is a mathematical definition of the difference between intelligent risk-taking and recklessness. The image below neatly summarizes the results of the mathematics:

In the above graph, the middle point of the curve describes the optimal size of any given gamble.* Bet any less and you’ll fail to maximize your long-term returns. Bet too much and, even with an advantage, you’ll (eventually) go bankrupt. In practical terms, the graph describes the boundary between intelligent risk-bearing and doomed recklessness.

Paris or Bust

In 1924 Earnest Hemingway was a relatively unknown reporter in working in Toronto. Sick of his day-to-day duties and yearning for a return to the romance of Paris, Hemingway and his wife Hadley broke their lease and fled back to the left-bank.

This was the Hemingway’s first risky decision. The move meant foregoing the substantial salary Hemingway had been earning in Toronto. With their first child just over a year old, this was a daring and some might say reckless decision for a young family.

However, given that the Hemingways had lived for several years in Paris prior to this and knew the city, the people, the cost of living, I would submit that their decision was a form conscious risk-taking. They knew the terrain, and thus to a degree, what could wrong. Plus, they had Hadleys small but not insubstantial trust fund to live off of.

Hadley had a trust fund, bestowed upon her by a banker grandfather; she called it “my sweet little packet of seeds.” It would give the Hemingways $2,000 to $3,000 a year to play with. It was a relatively modest meal, but nourishing enough. – Everyone Behaves Badly, Lesley Blume

Unfortunately, what the Hemingway’s did next proved to be even less calculated and ultimately reckless.

Upping The Ante

Not long after arriving in Paris, Hemingway’s determined that Hadley’s trust fund was being managed too conservatively. Perhaps out of a desire to generate more income to fund their lifestyle, the couple directed that their investments be managed more aggressively.

This decision was reckless first and foremost due to their personal circumstances. With neither working and a young child to provide for, no modern financial advisor worth their salt would recommend or allow an aggressive portfolio.

Recklessness, as described by the Kelly Criterion is a matter of intensity; bet the ranch for long enough and you’ll eventually lose the farm. But in practical terms, there is another variety of risk which is so often a precursor to recklessness that is a species of the thing in its own right. I call it domain risk.

Domain risk manifests when we move from one domain to another, often without realizing it. Think of the race-car driver who tries to ski like an Olympian or the business tycoon who gets burned playing his hand in the art world. When we move outside what Warren Buffett calls our circle of competence, we expose ourselves to new dimensions of hazard.

The Hemingway’s third decision exposed them to domain risk and the results were disastrous. As Lesley Blume recounts in her book, Everybody Behaves Badly,

The couple had concluded that their trust company was too conservative, and instead handed over management of the fund to the husband of a friend of Hadley’s. This wizard not only managed to halve the fund’s capital but also even left the Hemingways without an income for several months. Hemingway squandered precious hours trying to trace the trail of the lost funds, but the couple was ultimately left bewildered and nearly destitute.“It was my ‘complete poverty’ period,” Hemingway reportedly told a friend later.

The Hemingway’s decision to change their financial manager was a subtle but important second dimension to their recklessness. In addition to additional market risk, they exposed themselves to manager risk. As their unfortunate outcome demonstrates, knowing what risks you’re taking is as important as knowing how much risk you’re taking.

The Line

The Hemingway’s were artists and as such perhaps it was in their nature to push things to the limit. Ernest Hemingway was famous for his admiration of bull-fighters and mountain climbers, endeavors where success requires a finely calibrated ability to balance exposure and self-preservation. I, for one, find it revealing that when Hemingway wrote about what he admired in a bullfighter he did so in mathematical terms which echo the Kelly formula:

Romero’s bull-fighting gave real emotion, because he kept the absolute purity of line in his movements and always quietly and calmly let the horns pass him close each time. He did not have to emphasize their closeness. Brett saw how something that was beautiful done close to the bull was ridiculous if it were done a little way off. I told her how since the death of Joselito all the bull-fighters had been developing a technique that simulated this appearance of danger in order to give a fake emotional feeling, while the bullfighter was really safe. Romero had the old thing, the holding of his purity of line through the maximum of exposure, while he dominated the bull by making him realize he was unattainable, while he prepared him for the killing. – Ernest Hemingway, The Sun Also Rises [emphasis added]

It’s worth noting that in this case mathematics provides the illusion of precision. In real life, the boundary between risk and reckless is almost never a bright line. Some people cope with this uncertainty by being ultra conservative and forgo the potential benefits of intelligent risk-bearing. Others have an appetite for risk that often crosses into recklessness and like Odysseus, have to find ways to chain themselves to the proverbial masts. And still a third class possess an intuition for hueing the line – the people who can just smell a good deal.

Being aware of our own proclivities to risk can be the best defense against erring toward conservatism or recklessness. In building and maintaining that awareness, it often helps to have a trusted third-party as a sounding board.

*Image Source: Fortune’s Formula, William Poundstone