Understanding Risk

The word risk gets thrown around often, but few people stop to think about the concept, and its implications and even its meaning.

Risk, defined as the probability of permanent loss of capital, has three types:

• Financial risk (leveraged balance sheet),
• Business risk (loss of earnings power, usually as competitive advantage disappears), and
• Valuation risk (paying too much for a business).

Each type of risk has two components:

(a) Probability of failure for the business we invest in, and

(b) Consequences and severity of failure

The concept of investing is to pounce when the expected value, defined as the sum of all possible values each multiplied by its probability of occurrence, is clearly in your favor. That happens either when the likelihood of failure is very small and the consequences of failure are reasonably low, or when the likelihood of failure is large but the severity of failure is negligible and the reward in case of success is very large. But it is never a good idea to invest if the severity is large, even if the probability of failure is low, so you should rule out all investments that can go to zero or that have a large downside.

Incidentally, this is not the way academia looks at risk.

In 1997, the Nobel Prize in Economics was awarded to Robert Merton and Myron Scholes for their option pricing formula. The Black-Scholes formula key inputs include expectations for volatility, interest rates and dividends, despite the fact that accurately predicting those is not something anyone has been able to do consistently.

In 1990 William Sharpe and Harry Markowitz won the Nobel Prize in Economics for their Modern Portfolio Theory (MPT) and Capital Asset Pricing Model (CAPM), which are based on equally dubious assumptions and aim to calculate the risks of investment portfolios. MPT revolves around many formulas replete with Greek letters, and talks of “Sharpe ratios”, “correlation" and value at risk, fancy theories that tell you the events we have been witnessing over the last 18 months could not happen in 1,000 years.

CAPM relies on the cost of capital. Nobody knows how to calculate cost of capital, but Professor Sharpe was awarded the Noble prize for his claim, and I am simplifying, that if you assume investors are rational, expect to maximize their wealth and make their decisions based solely on the expected average return and its standard deviation, then the cost of capital can be measured by a formula involving the Beta coefficient.

Of course, none of these assumptions hold in the real world. But more importantly, that central factor Beta is completely irrelevant in estimating the probability of loss or the range of values of that potential loss. Beta equates volatility with risk, and claims that as a stock declines, it becomes a riskier investment simply because its volatility has increased. It ignores the fact that an investment is more attractive AND less risky if made at a lower price.

This should be obvious: Wouldn’t you prefer to buy the house down the street at a lower price? Wouldn’t you consider that same house to be a better investment, with bigger upside and smaller downside, at a discounted price?

What the modern pseudoscience academia loves so much is folderol. There is no other field where academia has so brazenly ignored the practitioners, and done so with impunity. I suppose a tenured professor simply has too much invested in abstruse equations to admit they are all bunk (as Charlie Munger likes to say, to a man with a hammer everything looks like nails), but the sole benefit of those theories is to make astrology look good.

As mathematician Benoît Mandelbrot showed, and Nassim Nicholas Taleb popularized, only fools are surprised by the irrelevance of these academic concepts. But many people took them seriously and ended with great trouble. Among those were the folks at Long Term Capital Management, a now infamous institution which ran a highly levered investment fund based on the theories of several Noble Laureates they had on staff. The fund collapsed in 1998, wiping out its partners’ entire investment.

More recently, large financial institutions such as Lehman Brothers, Bear Stearns and Citigroup (C) were managed in accordance with those theories, imperiling the entire world financial system.

Alfred Nobel envisioned a prestigious prize bestowed on those who promoted science, but he got the haphazard gang of fools mentioned above.

So how do you protect yourself and control risk in the real world?

First, remember that a successful investment strategy has capital preservation as its guiding principle, and is therefore focused on avoiding losses and guided by probabilistic decisions. As far as I can tell, there isn’t some kind of risk goddess that grants you a high return at year-end if you took major risk all year. In fact, the more risk you take, the more likely you are to get in trouble and sustain losses.

One of the important and overlooked realities in the field of investing is that you can make low risk, high return investments. Moreover, that is the only intelligent way to invest. And yet, not only is that truth not widely known and followed, it is actually counter to what is preached in academia, and the opposite of what is believed by most amateur investors. Many investors typically suffer losses by knowingly pursuing high risk speculative investments, believing they will be rewarded with high returns (and as we have seen recently, even some sophisticated investors suffer losses following risky, speculative investments they think are safe).

Second, buy only when a margin of safety exists. Margin of safety is the difference between price (what you pay) and value (what you get), and it is the heart and core of the investment business.

Third, remember that valuation models are rough guides for the value of individual stocks under normal circumstances. In other than normal circumstances, emotions rule and formulaic models are useless. Markets are often efficient but certainly not always, and if you are taking your cues for the value of a company from the market quote, you should not be buying stocks.

Fourth, ignore the rampant use Wall Street does of proxies to cash flow, such as EBITDA or EBITDAR. Those are essentially tools to distract from the real performance of the business.

Fifth, don’t forecast. Mankind always desired to know the future, and this is exploited just as any other human passion. The purpose of a margin of safety is exactly so you don’t have to forecast.

Indeed, it has been said there are three main types of forecasts. In order of increasing sophistication, they can be referred to as the naive, the gullible, and the expert. The naive forecast is based on trend extrapolations. The gullible forecast is based on analysts' estimates. The expert prediction is based on rigorous study of a company, its industry, and the economy. Those are often the worst, because valuation schemes derived by theories such as CAPM are not only unhelpful but also counter-productive, in that they create false precision.

Very few people can consistently predict macro economic events. The only thing you can do is think about individual business values and make rational judgments about them, building an investment portfolio with the odds stacked in your favor.

Comments

[Alan von Al...:]

Brilliant and concise. Thank you, sir.

May 12 05:59 AM

[iknoknot:]

Great read! tnx,

The quandry for me, is my urge and efforts to quantify risk with metrics, measurements, and weighting factors. These metrics are generally meaningful in their accuracy and audit-ability (e.g. book value is pretty measurable). And... these same 'tools' seem to get me through my daily life on the road, in sports, etc.

But stack these measurements (fundamentals) against TA, trends and emotional bubbles in this wild market, and it seems not to make much of a difference - and this last market dump (2008/9) blows away any urge to 'go long' through the noise to capitalize on the signal.

I'm currently trying to assess the risk of involvement, rather than any particular vehicle...

be well,

--ikk

May 12 06:09 AM

[Allan Frain:]

There are none so capable of self-delusion than academicians. It seems manifest in a yearning for that "new paradigm"--a term so often heard during the recent bubble years.

May 12 09:00 AM

[Allan Frain:]

The follow-on is understanding that risk analyses in the bailout era is a matter of knowing when government will intervene in the market and on whose behalf. If you're GS you can influence as well as predict.

May 12 09:03 AM

[Living4Divi...:]

Good article - I like your philosophy

May 12 09:35 AM

[Ferdinand E...:]

"...based on the theories of several Nobel Laureates..." At least half of the Nobel Laureates in economics could be anybody, and the gents on the Nobel committee are very definitely a pathetic group of human beings. But one of those Nobels at LTCM was Robert Merton, and he is strictly a heavyweight, regardless of what happened to that firm.

May 12 09:46 AM

[Ivo P. Jane...:]

Malsow and Nobel: Couple of clarifications:
The quote that you ascribe to Charlie Munger, “a man with a hammer everything looks like nails” actually belongs to Abraham Maslow (1908-1970) which reads: “if the only tool you have is a hammer, you tend to see every problem as a nail.” www.quotationspage.com.../

The other clarification is regarding your the Nobel Prize in Economics comment: “Alfred Nobel envisioned a prestigious prize….” Below is a short explanatory note from Wikipedia: “The Nobel Prize in Economics[2] … is identified with the Nobel Prizes, although it is not one of the five Nobel Prizes (in Physics, Chemistry, Physiology or Medicine, Literature, and Peace) which were established by the will of Alfred Nobel in 1895.[1][3][4][5][6] The Prize in Economics, as it is frequently referred to by the Nobel Foundation, is a prize established and funded by the Bank of Sweden, in memory of Alfred Nobel.” en.wikipedia.org/wiki/...

May 12 10:44 AM

[reluctantQuant:]

Love the point on forecasts, which are the bane of a trader's existance. Let's look no farther than the weather. I'll be more capital has been invested in forecasting the weather than any other thing in the history of mankind. Trillions? Probably. How are they doing with weather forecasting? Anyone got a good picture on late June?

Of course, they did get a lot better when we learned to fly...

--rq

May 12 10:57 AM

[Pj568:]

Agreed. Defining Risk is like defining Value or Financial Analysis, all are nebulous terms. We must also recognize they are constantly changing and require periodic reevaluation. Unfortunately there are so many risks that can't be quantified.

There are some great formulas available for each but as in all of finance they have to be subjectively applied and we often misinterpret and misapply based on our knowledge level. As we constantly see even the best academics and investors are often wrong at some point in time.

Can a trader/investor adopt a philosophy and stick to it even though the market doesn't agree? Is that even the right approach? It seems more like we are required to go with the market using just a portion of our philosophy but be able to realize when the market shifts. Being able to manage the money management side (our allocations and affordable loss) is probably the best we can do. Even these are Herculean tasks for us mere mortals.

May 12 11:05 AM

[Dave Shafer:]

Nicely written. Buffett and Munger have established the logic of margin of safety and those that invest in them have been rewarded. Do your best to emulate them and react as necessary to events as they happen!

May 12 11:26 AM