Reblog: The Illusion Of Risk

When we find an attractive stock to invest in, we outlay money, aka invest, to earn an attractive return and the investment will involve a degree of risk.

One of the most dangerous, commonly accepted and ill thought out concepts in investing is the risk / return trade off.

That is: high returns equals high risk.

Unfortunately, Investopedia continues to spread this type dogma, as you can see by the graph below.

Illusion Of Risk

Volatility (standard deviation) is not risk!

The appropriate definition of risk is from the Oxford dictionary (or any other branded non-financial dictionary) as: Exposure (someone or something valued) to danger, harm, or loss.

And in particular to investing, the risk is absolute loss.

Don’t take my word for it, let’s see how other successful well-known investors define risk.

Howard Marks talks about, in this interview with the Manual of Ideas team, risk and how it is tied to superior returns.

Seth Klarman wrote that risk is: “described by both the probability and the potential amount of loss.”

And Warren Buffett concluded that, “Risk comes from not knowing what you’re doing.”

But why do so many financial commentators continue to talk and write about it? Probably due to not having skin in the game, there is no loss to them if a reader drinks their cool aid and loses money.

From the unhelpful Investopedia graph above, we see that volatility is referred to as standard deviation, essentially changing an age old definition of risk. This, so-called risk, is referred to as Beta in the market.

…and BETA IS NOT RISK!

Beta is a measure of volatility, the movements of share prices, but it was created to allow a pointless comparison of one stock prices movement to other stocks, and to the market itself as a whole.

The urban dictionary has a more appropriate definition of Beta; a beta is a male who, instead of being alpha and manning up, completely bitches out. Can apply to many situations, but often refers to scenarios with women [and investing].

Guy 1: Bro, hook me up with that girl’s friend. [Bro, the beta on that stock is high]

Guy 2: [Fuck that. I’m going to double up with both of them. Stop being such a beta. [Fuck that. I can earn a high return off that stock. Stop being such a beta boy.]

This example below, is why, assigning risk to beta, and just using beta in general, is a pointless exercise.

Say, for example, we purchased 1,000 shares in XYZ stock at $1 per share and it has a beta of 1.05 (a beta of 1.0 appropriately offers the lowest risk). We fail to do the appropriate analysis and find out XYZ is fraudulent and suddenly declares bankruptcy, resulting in the stock price going to zero.

In this example we have lost 100% of our investment. Simple right. Oh and by the way, that simple example is a real life example, the business was Enron!

Now consider this scenario.

ABC stock meets all our investment criteria, little to no debt, healthy free cash flow and high rate of return on equity, and its stock is trading at a price of one-fourth (1/4) of the then per-share business value of the enterprise. The majority of financial analysts and financial media commentators would have estimated the value of ABC’s intrinsic value at $400 to $500 million. ABC’s market capitalization of $100 million was published daily for all to see.

What is the risk?

Has the fall in ABC’s stock price, now representing one-forth of it’s value, increased it’s risk?

No, the risk hasn’t increased but decreased.

The premise that higher returns equal higher risk is a misguided generalization, not based upon logic.

Why?

The above scenario was real, the stock was the Washington Post Company (WPC) and Warren Buffett described the purchase in his 1985 letter to shareholders.

Excerpt below (source). [Emphasis mine]

“We mentioned earlier that in the past decade the investment environment has changed from one in which great businesses were totally unappreciated to one in which they are appropriately recognized. The Washington Post Company (“WPC”) provides an excellent example.

We bought all of our WPC holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise. Calculating the price/value ratio required no unusual insights. Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did. And its $100 million stock market valuation was published daily for all to see. Our advantage, rather, was attitude: we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.

Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell. This now seems hard to believe. However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory: the stock market was totally efficient, and therefore calculations of business value – and even thought, itself – were of no importance in investment activities. (We are enormously indebted to those academics: what could be more advantageous in an intellectual contest – whether it be bridge, chess, or stock selection than to have opponents who have been taught that thinking is a waste of energy?)

Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew. Nevertheless, by yearend 1974 our WPC holding showed a loss of about 25%, with the market value at $8 million against our cost of $10.6 million. What we had thought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.”

This last paragraph is important as it describes one of two important ideas all investors need to apply.

“The stock investor is neither right nor wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.”

As Epictetus recommended in Enchiridion;

‘Impression come to us in five ways: things are and appear to be; or they are not, and do not appear to be, or they are but do not appear to be, or they are not, and yet appear to be. The duty of the educated man in all cases is to judge correctly.’

In the case of Washington Post: they are but do not appear to be.

Returning back to our premise of why ‘high risk equals high returns’ is plain wrong because it is possible to reduce risk and earn high returns. This is exactly what all the great investors do, they focus on reducing risk first, and ‘what’s the downside?’ they ask. Because they know that if they protect the downside the returns will come as a result.

“In order to preserve capital and maximize value, 3G Capital believes that factoring in the downside of an investment is equally as important as the upside potential. This philosophy has helped the firm weather various global economic cycles.”

3G Capital

Let’s return and see how Buffett’s investment in Washington Post turned out.

“You know the happy outcome. Kay Graham, CEO of WPC, had the brains and courage to repurchase large quantities of stock for the company at those bargain prices, as well as the managerial skills necessary to dramatically increase business values. Meanwhile, investors began to recognize the exceptional economics of the business and the stock price moved closer to underlying value. Thus, we experienced a triple dip: the company’s business value soared upward, per-share business value increased considerably faster because of stock repurchases and, with a narrowing of the discount, the stock price outpaced the gain in per-share business value.” We hold all of the WPC shares we bought in 1973, except for those sold back to the company in 1985’s proportionate redemption. Proceeds from the redemption plus year-end market value of our holdings total $221 million.”

Buffett’s initial investment of $10 million in 1973, turned into a market valuation of $221 million 12 years later in 1985. When Washington Post was selling at one-fourth (1/4) its value in 1973, an approximate margin of safety of 75%, the risk has drastically reduced plus their chance of bankruptcy was virtually zero due to a large amount of cash at bank, but the possibility of generating high returns was plain to see for everyone. The only question no one could answer is when? When will the share market recognize Washington Post’s true value?

The Washington Post case highlights the fact that the lower its share price fell, the lower the risk of absolute loss fell with it, but the possibility of higher return grew. But according to academia volatility is a risk and is referred to as beta, here is an extract from Investopedia.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio, in comparison to the market as a whole. Think of beta as the tendency of a security’s returns to respond to swings in the market. A beta of 1 indicates that the security’s price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security’s price will be more volatile than the market. For example, if a stock’s beta is 1.2, it’s theoretically 20% more volatile than the market.

And it further added, ‘most high-tech Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk.’

Inferring that a stock whose share price moves up and down at a greater rate than the general market is considered riskier is nonsense and Charlie Munger has said, “This great emphasis on volatility in corporate finance we regard as nonsense. Let me put it this way; as long as the odds are in our favor and we’re not risking the whole company on one throw of the dice or anything close to it, we don’t mind volatility in results. What we want are favorable odds.”

“Not being able to know the future doesn’t mean we can’t deal with it. It’s one thing to know what’s going to happen and something very different to have a feeling for the range of possible outcomes and the likelihood of each one happening. Saying we can’t do the former doesn’t mean we can’t do the latter.”

Howard Marks – Memo on Risk (Source)

What Risk Really Means by Howard Marks

In the 2006 memo and in the book, I argued against the purported identity between volatility and risk. Volatility is the academic’s choice for defining and measuring risk. I think this is the case largely because volatility is quantifiable and thus usable in the calculations and models of modern finance theory. In the book I called it “machinable,” and there is no substitute for the purposes of the calculations.

However, while volatility is quantifiable and machinable – and can also be an indicator or symptom of riskiness and even a specific form of risk – I think it falls far short as “the” definition of investment risk. In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, “The prospective return isn’t high enough to warrant bearing all that volatility.” What they fear is the possibility of permanent loss.

Permanent loss is very different from volatility or fluctuation. A downward fluctuation – which by definition is temporary – doesn’t present a big problem if the investor is able to hold on and come out the other side. A permanent loss – from which there won’t be a rebound – can occur for either of two reasons: (a) an otherwise-temporary dip is locked in when the investor sells during a downswing – whether because of a loss of conviction; requirements stemming from his time-frame; financial exigency; emotional pressures, or (b) the investment itself is unable to recover for fundamental reasons. We can ride out volatility, but we never get a chance to undo a permanent loss.

Of course, the problem with defining risk as the possibility of permanent loss is that it lacks the very thing volatility offers: quantifiability. The probability of loss is no more measurable than the probability of rain. It can be modeled, and it can be estimated (and by experts pretty well), but it cannot be known.

…

The key point in this memo is that the future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.

Where do we find Risk?

So, we have determined that risk is not found in share price movements, as share price movements are the reflects based in the short term on the consensus perception of all share market participants, and in the long term on the business’s performance.

The first-place risk is found is in the asset, and here is the definition.

Business risks result from significant conditions, events, circumstances, actions or inactions that could adversely affect the entity’s ability to achieve its objectives and execute its strategies.

Simple right, and when we conduct a full analysis of a company, we check off the list of things that can go wrong and assess that risk to the best of our ability.

The second-place risk is found is within us, the investor.

Our ability to assess the riskiness of an asset, our experience and knowledge will come into play. A lack of experience and knowledge increases our risk. Understanding our own limitations is an essential trait of successful investors.

And as Howard Marks says;

I think it’s very important that people be honest with themselves and really mark your portfolio of the market at the end of the year and say, “Which of the things that I thought would happen happened? Which of the things I thought would happen didn’t happen? Where was my mistake? Do I really have a superior ability to figure out which companies will succeed, which stocks are inexpensive, which risks are worth taking?

It’s not like getting a blood test, but it’s very, very important because you could waste your time and you could waste your life as an investor making average decisions. If you make average decisions, you might as well throw darts or invest in an index fund and get a job that you are better at.

Buffett and Munger recommend defining your circle of competence, then stay within it and everyday work to expand the boundary of your circle of competence. Developing the habits of reading and learning are essential to expanding the boundaries.

Takeaway