Thursday, January 9, 2014

Investment Risks

There is an old adage in investing that states the more risk one takes, the more return one should expect. Many investors understand that there is a positive relationship between risk and return.  Therefore, to achieve excellent investment returns, one must also take on a lot of risks. It may be important to step back and actually ask the  important question: What is risk?

There are many proposed definition for a very simple question. In this article, I will explore the conventional definition of risk and contrast that definition to what I believe is the real definition of risk in investing.

Risk Is Not Measured By Volatility Or Beta:
Any student studying finance in the classroom will learn that risk is captured by numbers such as standard deviation or variance, which measure an asset's volatility. The wider the price range of a security is, the riskier the security is assumed to be.

I see many problems with using volatility as a risk measure
  • Volatility can only reveal how crazy the price of a security moved, but it does not measure the probability of a loss or the possibility of a negative outcome
  • Volatility measures both bad and good outcomes when only the unfavourable outcomes should be the focus. For an investor with a long position, an extreme price move to the upside is a favorable outcome, not a unfavourable outcome
  • Volatility is calculated using past data and is backward looking. Many investors use historical volatility as a measure of risk. However, past data is a poor indicator of the future because financial markets usually moves in cycles. Periods of low volatility is usually followed by periods of high volatility. For example, volatility during 2005-2007 was extremely low. However, investors were incorrect to assume low volatility would continue in 2008. Although investors often extrapolate past data to predict the future, they should not forget that investing is a forward looking game. An investor who invest based on past data (like historical volatility) is similar to a driver who drives a car by looking at the rear-view mirrors. Warren Buffett made an excellent point that if history was the road to riches, then the Forbes's list of Billionaires should be all librarians.

Another measure for risk is beta, which is the correlation between the security and the market. In equities, the market is represented by the S&P500 index. A stock with a high beta is considered more riskier than one with low beta. Similar to volatility, beta also has serious flaws as shown below:
  • Using beta as a risk measure, a stock with a higher beta (fallen more than the market) is considered riskier. However, shrewd investors like Warren Buffett argue that the opposite is true. If a stock has fallen more than the S&P500, the lower valuation of that stock makes it less riskier, not more riskier. Beta does not take into account valuation levels. A lower price raises the expected return of the stock if the fundamentals of the company is not permanently impaired. 
  • Similar to volatility, beta is calculated using historical prices and is backward looking. Investors who bought financial stocks with low betas in 2007 believed they were buying quality investments with low risk. The low betas completely ignored the 30:1 leverage ratios many of those financial institutions possessed. After a 75-90% decline many of those stocks experienced, betas for those stocks increased significantly. Investors started selling these financial stocks regardless what the price was because the higher betas implied high risks. How can a stock that dropped more than 75% considered more riskier than before the large price drop?

I believe measures such as volatility and beta are commonly used by investing professionals because many investors want an exact number to indicate the riskiness of an investment. However, the future is inherently uncertain and I think it's a mistake to quantify the riskiness of an investment, especially using past performance as guidance.  In the words of Buffett, "In their [academics] hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than preciously wrong."  

In my opinion, volatility only measures how crazy the price of a security moves. Beta only measures the correlation between the security and the market index. Wider price fluctuations or higher correlations with the market does not imply higher risk.

Risk Is Not  Measured By What Mr.Market Says:

Some investors believe that an investment is considered more risky if unrealized losses continue to grow. On the other hand, unrealized gains may persuade investors that the investment is less risky because it appears the only direction the asset is heading is up. Investors should not allow Mr.Market (an allegory Ben Graham created to describe the behaviour of the financial markets) to decide which investments are riskier and which ones are not. Graham reminded investors that, "You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."

The old rule on Wall Street is for investors to "buy low and sell high". However, majority of investors practice the exact opposite of "buy high and sell low". Aliens from Mars may scratch their head at how dumb we humans are. However, many investors "buy high and sell low" because they sell the majority of their holdings when unrealized losses are high during bear markets and buy them back again when prices are much higher in the following bull market. Investors are convinced, due to their large unrealized losses, that prices will only continue to decline further until it hit the floor and hence conclude their stocks are risky because they are heading to zero. On the other hand, the exact opposite sentiment prevails during bull market tops: investors believe prices will climb to the sky and conclude that stocks are less risky because they can only appreciate. By associating risk with price advance or decline, investors are more likely to "buy high and sell low" instead of "buy low and sell high". Mr.Market does not tell you which investments are risky and which ones are not. Investors need to evaluate the risks themselves.

The Definition of "Risk" in Investing:

I believe the definition of risk should clearly defined as: "the possibility of a permanent loss of capital". An investment is considered risky if there is a high chance of a permanent loss of capital. The definition of permanent loss simply implies that the investor is likely to lose money because the underlying fundamentals are poor or negative outcomes are more likely to occur. The definition of risk above is appealing because it's more generic and focuses on the possibility of a permanent loss of capital, rather than temporary loss.

Assessing Risks:
When assessing the risks, it is important to consider a wide range of outcomes instead of just listing the bull case, the bear case and the base case.  Value investor Howard Marks encourages investors to evaluate risks by considering a distribution of outcomes and consider the likelihood of those outcomes being realized. In my own experience, I learned that my worst case scenarios were too optimistic and I missed important risk factors because I considered them as improbable. Instead of evaluating risk as a discrete distribution with a few cases,  investors should evaluate risk as a continuous distribution. The expected outcome of the distribution is just as important as the shape of the distribution.

It is important to assess the risks to any potential investment. Below I listed some points to assess risks for an equity investment and fixed-income investment.  
Examples of assessing risks with equity investments:
  • Investors should pay attention to the valuation of the stock. High valuations, such as stocks trading at extremely high multiples, will lower the future expected return and raise the overall risk level of the investment. If an investor pays a very high multiple for a stock, the expected return will be negative.  At the height of the bubble, investors were paying 100 times earnings for many technology companies. The negative returns that followed the crash did not surprise those who paid attention to the valuation levels and recognized the risk of paying too much. 
  •  For equity investors, the quality of management can have a significant impact on their investments. Buying a company with a incompetent management will significantly reduce future returns because poor capital decisions will significantly reduce earnings and cash flows, the determinants of future stock prices. Investor should assess the likelihood of poor capital allocation including the possibility of spending free cash flow on empire building or investing in low return projects instead of paying a dividend or conducting share buybacks. Warren Buffett provided a simple advice to lower management risks, "invest in companies that idiots could run, because someday one will".   
  • Industry risks are also important to consider for equity investors because numerous companies are constantly challenged by newer technology. Twenty years ago, it was impossible to imagine Eastman Kodak would be forced into bankruptcy because it was a dominate player in the film industry. Investors were blinded by Kodak's past success and failed to evaluate all the negative outcomes such as the disruption of digital camera by Fuji and Canon. Again, investors were looking at the rear-view mirrors instead of looking straight through the windshield and failed to consider all the possible outcomes of investing Kodak. Failing to consider the industry risks carefully can be extremely costly. Warren Buffett reflected his mistake of investing in Berkshire Hathaway (the original textile maker) in the 1989 Berkshire Letter: "When a management with a reputation for brilliance tackles a business with a reputation for a bad economics, it is the reputation of the business that remains intact"

Examples of assessing risks with fixed-income investments:
  • Fixed-income investors should also consider valuation levels, but in terms of yield spreads instead of price multiples. In 2007, the yield spreads on junk bonds relative to US treasuries was only 250 basis points. The high valuation will depress future returns and increases the overall riskiness of the investment. As junk bond investors experienced in 2008, the 250 basis point spread paid in 2007 was too rich and the yield spreads blew up to over 2000 basis points. The price investors pay is key to assess the overall riskiness of investment. The opposite was true in 2009 when spreads were above 2000 basis points on junk bonds and investors were more than compensated for the credit risks they were taking on by buying junk bonds.
  • Fixed-income investors should especially pay attention to balance sheet risks because they are the first in line to receive payouts if a firm liquidates. Investors purchasing bonds issued by companies with little tangible assets has very little margin of safety. Therefore, investors should carefully assess all the asset values of the company under all possible economic conditions. If once in a century event occurs, can the liquidating value of the assets cover majority of the principal value?

Managing Risks:
Why is important to manage risks when investors are not rewarded for being prudent risk managers? It may be intuitive but investors forget that great investing records are built by avoiding large errors. That is why Warren Buffett's fundamental tenet is "Rule 1: Don't Lose Money, Rule #2: Don't forget about rule #1"

Most athletes understand that in order to win a race, they must first finish the race. The same motto of  "To finish first, you must first finish" should be followed by investors as well. If investors do not practice prudent risk management, they may face the same situation LTCM (a hedge fund that lost a significant amount of its capital) experienced in 1998. Investors should always remember that if they manage to lose almost all of their capital, there is no chance of returning to the starting point. A zero multiplied by anything is still a zero. Charlie Munger stated that Berkshire Hathaway was very successful because he and Buffett avoided "stupidity". Mitigating unnecessary risks is a brilliant method of building solid returns over the long run.

Managing risks involves having a thorough understanding of the risks involved in any investment and being able to take on risks intelligently. Investors need to understand what the real risks are. Paying too much for any investment is a big risk while higher volatility is not. Investors should recognize the possibility of a permanently loss of capital and take actions to avoid negative outcomes. This involves recognizing and controlling the risks involved with their investments.

Misconceived Risk = Opportunity:
Most successful investors understand the importance of taking advantage of misconceived risks. Because most finance professionals still measure risks in terms of betas and volatility, there will be profitable opportunities during bear markets to buy assets considered risky by most investors but the underlying investment itself is actually not risky. During bear market declines, investors will sell a stock because the volatility or beta has increased, implying the stock is now more riskier under modern finance theories. However, intelligent investors understand that large price declines, which increase volatility and beta, actually decrease risk. The lower price level enhances future expected return and offers a larger margin of safety for investors assuming the fundamentals of the stock are not permanently impaired. Valuations and fundamentals are key to assessing risks involved in any investment. The 2008 bear market presented patient investors the opportunity of a life time because the herd was judging risks in terms of volatility and price declines rather than absolute valuations. Misconceived risks often present wonderful opportunities.

The opposite is also true in bull markets. Low volatility and large price advances creates a false sense of security among investors. After a long period of price advance, investors will forget to check the necessary blind spots and assume risk has been banished. This common misconception is very prominent during the height of bull markets such as in 2000 and 2007. Intelligent investors who understood the real risks would have sold (or even shorted) technology companies in 2000 and financial companies in 2007.

In both cases, misconceived risks by the herd creates opportunity for investors who take the time to evaluate the actual risks and understand when risk is misunderstood. Those who did their homework will be handsomely rewarded.

Miscalculated Risk = Fiasco
Mis-calculated risks can result in a disaster. The financial crisis of 2008 provides a perfect example of how risk was miscalculated. Fixed income investors believed risks could be banished by slicing mortgages and other loans into tranches. Equity investors believed risk was low because the low interest rate would support the use of leverage indefinitely. The danger of extrapolating near term trends many years into the future can be very dangerous. Investors should rely more on their common sense rather than the past to evaluate risks.

As Howard Marks puts it: "There are few things as risky as the widespread belief that there's no risk". No four words are more dangerous in investing than "this time is different". In the words of George Santayana, "Those who cannot remember the past are condemned  to repeat it"

Understanding risk is important for investors because investing is a forward looking game and the future is uncertain by nature. It is important for investors to realize that the standard risk measures are deceiving and do not measure the actual risks to an investment. Howard Marks nailed the definition of risk with his own statement: " risk means uncertainty about which outcomes will occur and about the possibility of loss when the unfavourable ones do".

After reflecting on the mistakes of other famous investors and my own personal mistakes, I believe evaluating the risks to any potential investment is key to guaranteeing satisfactory results. Evaluating risks before making any investing is important. Minimizing risk will boost future returns, which contradicts the positive relationship between risk and return. Taking on more risks increases expected return, not actual returns. Expected returns is increased because taking more risks increases the possible outcomes of the investment (both good and bad), which increases the expected or average future returns. However, I prefer to increase future expected return by avoiding unfavourable outcomes and maximizing favourable outcomes.

All in all, I created my motto of "Misconceived risk = Opportunity, Miscalculated risk = fiasco" to use in my investment decisions. Bear markets presents excellent opportunities for value investors who spend time to understand the "misconceived risks" by the market and take advantage of the bargains created by these misconceived risks.  On the other hand, bull markets presents excellent opportunity for value investors to sell their holdings to market participants who miscalculated risks involved. Minimizing risks is key to maximizing future returns despite many investors still believe they can only maximize future by taking on more risks. One common risk, identified by many famous value investors, is paying too much for an asset. Therefore, to minimize the risk of overpaying, always remember Ben Graham's words of "price is what you pay, value is what you get". 


  1. Kenny, I like your blog. When you say investors should evaluate risk as a continuous distribution, do you mean by doing a monte carlo valuation distribution? I have seen a few fund managers actually use this tool in their analysis. What's your thought on that?

    1. Thanks for the comment Irene. Glad to hear back from readers.

      Partly but I would expand to more than just Monte Carlo. It does provide a better picture of the distribution of outcomes and it's a good exercise but what I had in mind is what Charlie Munger calls "Mental Models" which of course includes Monte Carlo if one understands how to conduct the exercise. Viewing all investment outcomes using various angles using tools from math, statistics, psychology, economics, business strategy, and of course from the view of an actual business owner if it is a stock.

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