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Risk

Risk is a four-letter word. Like other less polite four-letter words, it is hard to imagine living without it. An understanding of risk is crucial in any attempt at becoming a competent investor. While risk may be unavoidable, its definition is, at best, fluid. Risk can mean different things to different people at different times. When investors discuss investing, they say “risk and return.” Risk first, return second. Likely they say it this way partly because risk rolls off the tongue better, but also because risk represents the fundamental building block of finance and investments.

If risk and return are a matched pair, why then is so much emphasis laid at the feet of risk and not returns? Returns are in a certain sense easy. Returns are visible. Whenever we turn on financial television or access the Internet, we are confronted with stock prices. Returns are not all that difficult to measure. In the vast majority of cases, to calculate returns we only need the change in price of a security along with any dividends or interest paid along the way. We also have pretty good return measures going back decades, if not centuries, across a range of countries and asset classes.

As transparent as returns are, risk is that much more opaque. If you ask most people what is risk in regard to investing, they would likely mimic the dictionary definition: “the chance that an

 investment (as a stock or commodity) will lose value.”

 There is no database where we can look up historical levels of risk for any security. We can't even state with any certainty the current risk of any particular security.

This lack of precision in the definition of risk left an opening for academia. Academic finance was forced to come up with its own definitions of risk. Depending on how you look at it, finance took a more mathematical route in defining risk. In the most established model of finance — the capital asset pricing model (CAPM) — risk isn't some measure of potential loss; rather it is measured by volatility, or the degree to which a security's price fluctuated in value.

 Finance types will recognize this as a gross simplification of the CAPM, but the fact is that volatility takes into account all price fluctuations, not just those that are negative.

In other models that followed the CAPM, there is also a linear relationship between risk and return. The higher the expected riskiness of an asset, the higher the expected return on the asset. Pretty simple. This is embodied in the phrase “nothing ventured, nothing gained.” It is important to recognize that we are talking about averages here, the theory being that, on average, higher risk is compensated in the form of higher returns.

Much of academic finance in the past three decades has been dedicated to showing the many ways in which the CAPM fails. Academics have created newer models that add additional factors to explain security returns, based on the assumption that these factors proxy for various kinds of risk, which presumably are compensated for on average and over time. In that time, academic finance has begun focusing on measuring risk when asset returns, and the overall economy, are performing poorly.

This academic conception of risk is very different from that of many investment practitioners. This difference is palpable in this quote by James Montier, who writes, “Risk is the permanent loss of capital, never a number.”

 Those investors who look at securities on a case-by-case basis — or in the parlance of the industry, from a bottom-up perspective — hew much more closely to our intuitive sense of the word risk.

These investors, often value investors, see not a linear relationship between risk and return but rather an inverse relationship. Those

 securities that are the least risky have the highest return potential. This is because these securities have been beaten down and the risk has been wrung out of them. In short, these assets have much less farther to fall and are therefore less risky.

Even in this world, the conception of risk is still opaque. No security comes attached with an estimate of its risk. Analysts are forced to make an estimate of a security's fair value. However, these fundamental investors feel that if they focus on securities that trade far below their fair value, they work within a margin of safety.

If you are able to unearth enough securities trading with an adequate margin of safety, you can generate returns both in excess of the market and with less overall risk, the idea being that this buffer between what a security's true value is and where it is trading will make up for any errors the investor makes in judgment or analysis. The concept of a margin of safety puts the risk management process at the forefront of investing. Noted investor Howard Marks makes the point by saying, “Skillful risk control is the mark of a superior investor.”

We would all like to be superior investors. However, as discussed in the introduction, that goal may be a stretch for many of us. You can bet that successful investors, like Howard Marks, got to that stage in part by focusing on risk management. Getting from one period to the next with your portfolio largely intact should be the first goal of any investor. In investing, like in a marathon, you can't finish the race if you don't pass each checkpoint along the way.

What should be clear is that whether you conceive of risk in this fundamental framework or in the academic sense, risk is unavoidable. Some people never take that first crucial step to becoming investors because they are paralyzed by the fear of investing. They feel that if they don't step off the sidewalk, they cannot be at risk from oncoming traffic. Unfortunately for them, they have not taken into account the possibility of a car making its way onto the sidewalk.

This somewhat gruesome analogy is important because financial risk is everywhere. It is explicit in the investments we already own. It is implicit in the trade-offs we make by choosing to invest or not invest. It would be great to believe otherwise, but a lifetime of investing is also a lifetime of risk taking.

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