When it comes to investing, we often hear the phrase ‘high risk - high return’. There isn’t much ambiguity or dispute on the understanding of 'return' and how it is computed. It is apparent in the total value of our portfolio, and is represented in ‘% growth’ terms - either as absolute growth, or IRR or CAGR or TWRR (as is often reported by funds) and the like. Risk, however, is another story altogether. It is understood differently by different people, with varying definitions (within the field of finance and outside) and sometimes misleading interpretations. Through this article, we attempt to try and understand, to the limited extent that we can - what risk is, what it is not, and how we could potentially deal with it.
The Finance version of 'risk' and 'volatility'
Most finance text books, funds' statistics, web sites on investing - would define risk as the volatility of returns, and is measured as a ‘Standard Deviation’ of returns (most often computed over the returns of the last one year). This is further expressed as risk relative to the market as 'Beta', and using these numbers a few more statistics such as 'risk adjusted returns' etc. are computed. However, fundamentally all of these are based on the assumption that risk = volatility.
At the core of it, volatility is the fluctuation of price or returns. It is easy to quantify and measure, there is no ambiguity in the understanding of volatility. It is a simple parameter which can serve as an input in predictive models. The issue with this, as Charlie Munger notes is:
“Practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important. That is a mistake I’ve tried all my life to avoid, and I have no regrets for having done that.”
In my opinion, volatility is one way risk manifests itself. Reducing risk to this one number (usually historical) is the equivalent of calling a symptom as the disease, leading to the wrong diagnosis and treatment. For instance, consider a stock you bought, which has doubled from Rs. 500 to Rs. 1,000 in 6 months, by any measure it would be high on volatility (as it has doubled quickly). Can we conclude this was a risky investment? Or if there has been a 45% price drop in a relatively healthy company with low levels of debt, due to an overall market crash (like the one in March 2020). Is is risky to purchase it now? - At least, I wouldn't think so!
Volatility is caused by a number of factors, and understanding and acting upon those causes would be more effective, rather than shunning volatility. In fact, volatility could actually present is with opportunities for making outsized returns with low risk!
To quote Warren Buffet on risk and volatility:
"We regard volatility as a measure of risk to be nuts. And the reason it's used is because the people that are teaching want to talk about risk. And the truth is, they don't know how to measure it in business. I mean, that would be part of our course on how to value a business. It would also be, how risky is the business? And we think about that in terms of every business we buy. And risk with us relates to -- Well, it relates to several possibilities. One is the risk of permanent capital loss. And then the other risk is just an inadequate return on the kind of capital we put in. It does not relate to volatility at all."
A common-sensical approach to understand Risk
So, if risk is not volatility, what is it? Let's look at the definition of risk from a dictionary:
"Possibility of something bad happening at some time in the future; a situation that could be dangerous or have a bad result" - Oxford dictionary
This kind of makes sense, at least to me. When I normally think about risk, I think of it as 'the likelihood of a negative outcome' - be it in investing, in starting up, in a business pitch, in proposing to your girlfriend (or boyfriend), or even in a trivial act such as crossing the road. It is the chance of losing something you value - your capital, your business, your revenue, your relationship, your reputation, or your life.
If we were to contextualize this to investing, we could adopt Warren Buffet's definition - "Risk is the probability of permanent loss of capital!" (you could extend the term 'loss of capital' to include the effect of inflation as that would also mean loss of capital in real terms)
Some thoughts on the properties of risk
Now that we have a definition of risk (in the context of investing), and hopefully agree that volatility does not do complete justice to the broad topic of risk, let's try and look at some properties which help us understand the beast better.
Risk inherently exists because the outcome is in the future, and by definition, the future is unknowable. And it is this uncertainty of the future which creates risk, making it very difficult to quantify.
Volatility is a temporary phenomenon, by definition. Risk is not. Volatility becomes risk when you do not have the capacity to weather the downside of that volatility - either because of leverage, or the need for funds at an inopportune time or due to your temperament (panic).
Just as there is a chance of losing something in the future, there is also the likelihood of an unexpected positive outcome - higher than expected returns, windfall profit etc. However, I would not associate 'risk' with this upside potential. I would rather call it as an optionality or an upside, maybe even anti-risk (why not?, we do have anti-matter!), but I would not term that as risk, while volatility normally would include swings in either direction.
While you may believe sky-diving is an exciting adventure, and would be thrilled to do it knowing that statistically it is extremely safe, there will be someone who believes it is an extremely risky endeavor, and it is just ridiculous to derive pleasure from jumping off a plane. Two sane and rational individuals may have a very different perception of risk of the same event, as against zero dispute on what the returns are. This, difference in perceptions is often what makes a market when one person sells something at a price which someone else pays to buy.
Another feature of risk is that by definition it ceases to exist the instant an event is complete, and because of this it often becomes invisible leading to errors in judgement. Let's say a fund manager made a return of 30% over the last one year. All you will see is this actual return of 30%. You will not know whether he made this by making a very safe mispriced bet in a stock with an extremely low downside potential, or whether he made it by betting on a penny stock which paid off, but could have easily lost 50%. In each of the cases there would be a number of future scenarios each with its own probability. However, once event is over, one of those scenarios has actually materialized, and the probabilities or the other scenarios are not relevant anymore. The only truth in front of our eyes is the return, and you will never know how much risk was involved - hence invisible!
Sources of risk, and how to manage it
There are many types of risk such as market risk, interest rate risk, currency risk, business risk, liquidity risk, and the list could go on. However, I like to classify risk based on the broad sources:
Not knowing what you are doing - The source of the largest risks, which is pretty much in your control, but heavily influenced by your biases. (E.g., business risk, industry risk, valuation risk, risk due to FOMO, risk of speculating while thinking we are investing etc.)
The vagaries of life - Which people try to forecast the most, with the success rate not better than a coin toss. This includes a large number of the 'types of risk' you would typically encounter in finance books (e.g., interest rate, currency fluctuation, market mood, regulation, geo-political tension, pandemic, bike accident, meteor hitting the stock exchange etc.)
Hubris and overconfidence - Making you more vulnerable to the vagaries mentioned above, amplifying its impact (e.g. concentration risk, risk of default due to high leverage, risk of abusing your boss etc.)
Now that we have the 3 sources of risk - lets look at how to manage the risk arising out of these sources. I deliberately choose 'manage' as it is impossible to eliminate risk given its relation to the future, which is always uncertain.
Not knowing what you are doing: Know what you are doing (Duh!)
1. Do your homework: This cannot be emphasized enough. We often look for tips, rely upon (so called) experts on TV, YouTube, blogs, social gatherings etc. for advice on where to invest, and take decisions to invest without knowing what we are getting into. Many of us spend hours and even days before buying a gadget (such as a smartphone) costing a few thousand rupees, while invest hundreds of thousands on Rupees in equities based on 'expert' 'tips'. The best way of reducing risk is by actually putting in the effort to thoroughly understand what we are investing in - analyzing what it's prospects are, assessing what challenges may be there, evaluating opportunities. Of course any amount of thorough analysis doesn't guarantee success, but it may at least help avoid some obvious traps.
2. Margin of safety: Look for asymmetrical bets - where there is a potential for a large upside and a limited downside. As Mohnish Pabrai, in his book, The Dhandho Investor, says "Heads I win, Tails I don't lose much". There are at least a few such opportunities in most market scenarios. Consider this brief example of a company called APL Apollo Tubes (used for the purposes of illustration, and not an investment advice), which makes structural steel tubes, used in construction. They are the largest manufacturer of this product in the country, and are moving into value added products, and the branded retail space. In March 2020 their competitors were reeling in debt, and unlikely to withstand the COVID-19 blow. On the other hand, this company was well capitalized, the market leader and quite profitable. It had capacities already in place, and invested in new technologies giving it a cost advantage. It was poised to take market share from its bleeding competitors and emerge stronger. In April 2020 this company was available for a PE of 12, a market cap of ~3,200 Cr for a company with trailing 12 month profits of ~250 Cr, reasonably higher discounted cash flow valuation with conservative assumptions, and high growth potential due to market share gains, value added high margin products, and branding push. The potential for downside was quite low at the price it was available for, with a high upside potential. It had a margin of safety. Here's Warren Buffet on Margin of Safety:
"If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety. So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay; but if it's over the Grand Canyon, you may feel you want a little larger margin of safety.."
3. Stay within your Circle of competence: There is this old story that the doctor looks for mining stocks the pilot invests in pharmaceuticals, and the miner in aviation, and probably all of them in the theme of the season - which, today, would include platform businesses, tech & digital companies, and contract manufacturing. Each of us have gained knowledge, developed expertise in some specific areas owing to our education, work experience, exposure of some sort - and that is our circle of competence. When we stay within that circle and invest, we understand what is going on (to a significantly greater extent than something which is outside the circle). We know what we are doing - and that helps manage risk.
This concept of circle of competence has been widely discussed by Buffet and Munger, and it is likely that many of you would have heard of it. Here's what Buffet said when he introduced the concept in his 1996 shareholder letter:
What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
The vagaries of life: Insure and Hedge
4. Asset allocation: Invest across a few asset classes (e.g., domestic equities, debt, gold, international equities etc.). Usually, all asset classes are not equally impacted, and this helps especially in cases of a shock - such as the 2008 Lehman collapse, or the COVID-19 pandemic. How much to allocate to which asset class is very specific to the needs and the temperament of an individual, and would be a separate discussion altogether.
5. Dollar cost averaging or SIP: We can't predict what can go wrong when, but we can reduce the risk of a single event causing a significant value erosion just after we invest by investing amounts periodically (say every month). This is a sensible hedging strategy for most investors, and has helped provide reasonable returns in equities by reducing event risk.
Hubris and overconfidence:
6. De-leverage: Leverage (or debt) makes you fragile. When you borrow to invest (on margin), you lose the ability to wait-out volatility, and are forced to sell at the worst possible moments. A leveraged business would not be able to withstand volatility in the business cycle. This is what happened to a number of investors and businesses in March 2020 because of leverage.
7. Diversify: Within an asset class, especially equity (and debt to a reasonable extent), diversify to prevent overconfidence from making a large portion of our capital vulnerable to risk - individual business risk, industry related risk or an unexpected regulation, causing a large capital loss. The diverse assets should not be very correlated (e.g., buying 4 private banks to diversify will not serve the purpose largely because all the stocks will have the same industry risk). A note of caution, on the issue of over-diversification because of a lack of understanding of what you are investing - is equally dangerous. Diversification is not a substitute for lack of effort on your part.
8. Embrace humility: Probably, one of the most important traits of a good investor. Humility, to accept I don't know everything; to understand I will be wrong however much I try; to acknowledge that there will always be someone else smarter, luckier, more sensible that I am. Humility keeps us tethered to reality, aiding good decisions - and that reduces risk. The added advantage - being a more tolerable, and potentially, more likeable human being! :)
I'd like to end this article with a few lines by Charlie Munger - which
“When any guy offers you a chance to earn lots of money without risk, don’t listen to the rest of his sentence. Follow this, and you’ll save yourself a lot of misery.”
I hope I was able to do some justice to this subject, which I am sure I will revisit, refine, and hopefully learn and share more about in the future. Do share it with like minded readers if you think this was worth reading!
Until next time!
Further reading on this topic:
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