Rethinking Investment Risk

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Includes: BRK.A, BRK.B, OAK
by: Kenny Yang

Summary

Risk is not measurable. Measures such as volatility, beta, or Value-At-Risk cannot be depended on to measure risk. Risk is about evaluating the possibility of permanent loss.

There is risk in investing because there are many possibilities and only one outcome. To evaluate risk, investors have to consider all possible outcomes and determine the likelihood of each.

The biggest risk is price risk for equity investors. If the price you pay is too high relative to the company's fundamentals (earnings, cash flow etc.), a loss will occur.

In Buffett's review of The Most Important Thing, a book written by Howard Marks of Oaktree Capital (NYSE:OAK), he stated that when he saw a memo from Marks in the mail, it is the first thing he reads. I share the same enthusiasm when I see a new Marks memo. He recently published a memo explaining investment risks titled "Risk Revisited." After reviewing the memo, I began to review my own philosophy about risk and wish to share some of my thoughts in this article, which is a continuation of a series of articles I am writing to explain my investment philosophy. My previous articles can be found here and here.

I will briefly summarize the key points in the Marks memo and add some of my own commentary. Then I will discuss price risk, which is the most important risk I believe equity investors should assess. Value investors who closely follow Oaktree and Berkshire (NYSE:BRK.A)(NYSE:BRK.B) should benefit from reading this article.

Volatility is Not Risk:

Marks dispelled the common belief that risk equals volatility. I wholeheartedly agree with Marks on the confusion between risk and volatility. In my own blog post titled Investment Risk, I wrote:

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 unfavorable outcomes should be the focus. For an investor with a long position, an extreme price move to the upside is a favorable outcome, not an unfavorable 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 move 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 invests based on past data (like historical volatility) is similar to a driver who drives a car by looking at the rear-view mirrors.

Why is volatility being used as the standard risk measure in finance after I listed several drawbacks of using that measure? The simple answer is that it is quantifiable. Volatility is easy to calculate and defend when you have an academic paper but is volatility the right measure that represents the main risk investors fear? For most investors, the greatest fear is the possibility of permanent loss, not the possibility of crazy price fluctuations. Therefore, the main investment risk for all investors is the possibility of permanent loss.

Marks listed two reasons why a permanent loss can occur. First, investors, who use volatility as the definition of risk, will realize a permanent loss when they lock in the loss when there is a downward fluctuation. Second, a permanent loss can be realized when the underlying asset itself is facing fundamental problems such as significant decline in cash flow or earnings.

In my opinion, many investors often realize a permanent loss when they sell into price declines, even if they are temporary in nature. The loss of conviction and high emotional stress can lead to irrational decisions when there is a downward fluctuation. Since volatility usually increases when stock prices go down (VIX was at 89 in October 2008 and only 13 today), most investors associate risk with volatility. Nonetheless, their main focus should be guarding against the risk of a permanent loss.

Principles In Marks' Memo:

There were several important points regarding risk that was presented in the memo, I want to quickly review some of them.

His first key point is investors should not view the future as a single fixed outcome that can be predicted. They should review the future as a range of possibilities and picture those possibilities as a probability distribution by assessing the likelihood of each outcome. I agree with Marks that the future is uncertain and a probabilistic approach is needed when thinking about the future. An investor's job is trying to decide which possibilities are more likely to occur and betting on the asymmetries. Although determining the probability is more qualitative and subjective, investors should still have an understanding of this probabilistic approach. As Charlie Munger stated on numerous occasions: "If you don't get...elementary probability into your repertoire,... you go through a long life like a one-legged man in an ass-kicking contest."

Marks' second point is derived from an Elroy Dimson (professor at London Business School) quote: "Risk means more things can happen than will happen." An investment is considered "high risk" when there is a large number of possible outcomes, which also imply a large number of possible negative outcomes. Because there can only be one actual outcome, the uncertainty regarding which of possibility will occur is a source of risk.

His third point and fourth point are somewhat related. His third point states that knowing the probabilities does not mean you know what's going to happen. The reason is explained in his fourth point: while many things can happen, only one will. Therefore, investors should not confuse what will happen with what is most likely (in terms of expected value) going to happen. While calculating the probability of each possible outcome is key to determine if any asymmetric opportunities exist, betting heavily on an expected is foolish especially when there is a tail risk.

Here is a very simple example I created to illustrate the point:

Asset A Return Asset B Return
Possibility 1 30% (with 50% chance) 10% (with 50% chance)
Possibility 2 -90% (with 10% chance) -10% (with 20% chance)
Possibility 3 10% (with 40% chance) 5% (with 30% chance)
Expected Value 10.0% 4.5%

While the expected return of asset A above is attractive at 10.0% (more than twice the return of asset B), there is a tail risk that can almost wipe out investors. Although the probability of the 90% loss is small at 10%, it doesn't mean it will never happen. While the chance of flipping 3 heads in a row is only 12.5% (1/8), don't be surprise if you flip a coin 3 times and the outcome is 3 heads in a row. To repeat what I stated in a different manner, don't associate what cannot happen with what is unlikely going to happen.

To summarize, while Asset A may have the higher expected value, asset B is much safer because it avoids extreme negative outcomes. In investing, it is essential to avoid losses. Hence, investors may have to choose the lower expected return possibility in order to mitigate risk. To quote Buffett: "We wouldn't have liked those 99:1 odds [referring to the fact he had a 99% probability of increasing his returns with leverage but faced a 1% probability of bankruptcy] - and never will. A small chance of distress or disgrace cannot, in our view, be offset by a large chance of extra points."

Some Additional Thoughts On The Memo:

Marks also discussed many forms of risk - such as credit risk, illiquidity risk, concentration risk, and leverage risk- in his memo. The main risk is the possibility of permanent loss as discussed above. The other important risk to consider is the risk of falling short. This is what Marks call "the risk of missing opportunities." Just because investors face a variety of risk do not imply that they should practice what Marks call "risk avoidance." Investing is all about assessing the risk and ensuring that the potential return is high enough to compensate investors for bearing those risks. Avoiding risk has the unintended consequence of also avoiding return as well.

Marks made several thought-provoking summaries at the end of his memo. First, he stated that risk is counterintuitive. The fear that the market is risky actually implies the market is safe. If a stock declines in price and investors perceive the stock as risky, that stock actually becomes less risky. Thus, the perception of the risk level with any investment is the opposite of what the actual risk level is. Second, Marks observed that risk aversion is the thing that keeps markets safe and sane. Therefore, investment risk is the highest when investors are risk seeking rather than risk averse (i.e. 2000). Finally, he discovered that risk is often hidden. Losses occur only when risk collides with negative events.

My favorite example of the previous point was AIG's (NYSE:AIG) decision to sell CDS in the late 1990s. The company made hundreds of millions in profit by selling credit insurance that was considered safe for the firm. The company made money for a decade before the risk associated with the CDS collided with a negative event, the housing meltdown. Hence, an investment that isn't showing any losses does not imply it is not risky.

Price Risk In Equity Investing:

Since I, like many other SA readers, focus mainly on equity investing, I wanted to spend the rest of the article discussing what I call "price risk", which is the most important risk I believe equity investors need to assess.

In my opinion, price risk is the risk of paying too much for the stock, regardless of the quality of the company. On the other hand, many investors believe price risk is the risk that the stock may face a downward fluctuation, which, in my view, should be classified as "perceived price risk", not actual price risk.

Why is price risk important? If an investor pays an excessive price (defined as a price that is significantly higher than the intrinsic value justified by the company's earnings, cash flows or assets) for a stock, it is very likely that a permanent loss will be realized because markets are weighing machines in the long run and will revert to a price that is justified by the company's fundamentals. Buying a stock at an exorbitant price is similar to buying a dollar bill for 50 cents.

On the other hand, buying a dollar bill for 50 cents can be very rewarding. A large favorable differential (50% or higher) between the market price and intrinsic value reduces the risk on the investment because the high return offered compensates you for taking on the equity risk. Also, when an investor buys a stock when everyone else perceives it as risky, the investment itself is actually not risky because everyone, who believed the investment is risky, has already sold it. This point connects with Marks' observation that risk is counterintuitive.

Moreover, by buying at a very low price compared to its intrinsic value, it mitigates potential negative outcomes that may impact the intrinsic value of the business. If a stock is worth $75 and I only pay $50 for it, I have a 50% margin of safety ($25 gain /$50 purchase price = 50%). Even if a negative event destroys $20 of intrinsic value and the market reflects that intrinsic value, I would still make 10%. However, if I paid $70 for the same stock and the negative event occurs, I would realize a 21% loss. Hence, Ben Graham always stressed the importance of a large margin of safety. It will protect against the potential negative outcomes and reduce the risk of a permanent loss of capital. All in all, I completely agree with Graham when he said: "..Distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY."

What about the "perceived price risk" I discussed earlier? Investors should take advantage of them. If price declines while the intrinsic value is unchanged, the initial bargain has become an even more attractive bargain. Because buying into price declines is against human nature, most investors do the exact opposite and sell into price declines. Therefore, I have two important reminders for investors when the stocks in their portfolios decline:

  1. If you have cash and the intrinsic value of the stocks remain unchanged, you should buy more. Everyone loves a 20-50% sale in the mall but has a completely different attitude in investing. Shopping in the mall and stock market is essentially the same. You buy when there is a sale.
  2. If you are fully invested and have no excessive cash on hand, you have limited flexibility. However, don't assess your portfolio based on the unrealized losses. Assess the stocks in your portfolio in terms of how much potential return they can generate based on current market value. Too many investors sell when unrealized losses become large without assessing the companies they are actually selling. If nothing fundamentally has changed while prices dropped, there is no need to sell. By selling, the investor would actually lock in those large unrealized losses.

Conclusion:

It is paramount for all investors to assess and manage risks in their portfolios. Risks have two dimensions. The obvious one is the possibility of permanent loss. The other overlooked dimension is the risk of missing opportunities. To balance the two aspects, investors should assess the risk of any investment carefully using a probabilistic approach and try to identify any return asymmetry in the list of possible outcomes. Invest in a stock (or any asset) only if the return promised (at the price you paid) will prove sufficient given the amount of risk taken. Never ignore any investment because of "perceived" risks. Any asset is a good purchase at the right price.

With respect to equity investing, I believe investors should watch price risk carefully and manage it by buying stocks at significant discounts to their intrinsic values. By buying cheap, investors will also have an easier time selling. Follow Oaktree's motto of "well bought is half-sold."

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and does not constitute an offer to buy or sell any securities discussed in the article. This article does not represent financial advice. Investors are recommended to conduct further due diligence before committing capital to any investment.