Risk Series Part 1: Understanding Risk

Risk Series Part 1: Understanding Risk

If there are two things an intelligent investor must pay attention to they are the price he pays to the value he receives and the amount of risk each investment withholds. Neglecting either of the two can leave someone with a lot of red in his portfolio and that is obviously something we want to avoid. I have never heard someone say they like losing money.

This article is the first article in my 3 part series about risk. What sparked this series was the book The Most Important Thing by Howard Marks (Affiliate Link). He has 3 chapters dedicated to risk and I think they all hold important knowledge everyone should know. Obviously, this series will give you a good amount of information but if you want it all go buy his book. It is incredible. Howard is well known for his memos he writes periodically and they are a cross between Warren Buffett and Michael Lewis. If you love investing, like me, you will take some time to read these. They are greatly written.

Risk Series Part 1) Understanding Risk

“Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable” – Howard Marks

Dealing with risk is essential. Every investment withholds a certain amount of risk. Of course, some have more than others but the only “risk-free” investment is a treasury bond. They have the lowest risk of all, so of course, they yield a very low return. Right now the 10-Year note is rewarding 2.4%. This barely covers the average rate of inflation.

Finding a good amount of investments that go up is great but if you spend no devoted time to identifying risk you’re putting yourself at a great disadvantage. Spend no time on risk and it is likely you will not succeed in the long run. There are 3 large reasons why you should devote time to identifying risk.

First) Risk is a bad thing. The goal of every investor is to avoid it or minimize it to the lowest possible level. Naturally, people are risk-averse, they want to stay away from it or have less than more. Because of this natural inclination, one must figure out how much is held within the investment.

Second) When you take the time to consider the investment an investor must make the decision by not only the potential return but the amount of risk entailed in the investment. Return is only half of the equation and sadly, often the only thing people pay attention too. Because humans dislike risk there needs to be a higher return promised in order to compensate for the extra risk being taken on. The investing formula consists of two things, calculating the amount of risk being taken on and the return potential. If the return potential is high enough to compensate for the amount of risk than it can be a solid investment. I have never heard of someone taking a risky bet without the promise of a higher than normal return is they are right.

Third) When you look at the results of an investment risk needs to be taken into account. It’s nice to see a 50% return but how much risk did you have? Was the amount so large that it caused you to lose sleep at night? Was this return achieved from risky or safe investments? Am I going to be able to replicate these returns on a consistent basis safely? High returns are nice but if you only have taken them into account when looking at results you’re only looking at half of the equation. Make sure you can say to yourself, “Okay, I got a 50% return but I took on a huge risk” not just an “I made 50% ROI on my money”. The latter will make you believe you can do it over and over again which can lead to massive losses. They are riskier for a reason. There is a much larger risk that you can lose money than make it.

The Common Misconception

Every risky investment must promise a higher return if they didn’t no one would buy them. It’s sad but during good times you will hear a lot of people say “Riskier investments provide higher returns.” But we as investors cannot depend on riskier picks to provide us with the higher returns. Let me be loud and clear: YOU ARE GUARANTEED NOTHING. If you take on a large amount of risk then the odds are you will lose money. If you are right it can be very rewarding but the odds are stacked against you.

I want to talk quickly about a feeling we all have that can have us lose a lot of money. For some reason, human beings believe they have the ability to pick the correct things even when the odds are stacked against them. They believe their intuition is better than the rest of humans. I can personally relate to this. I made a risky investment one time because I knew it would go up. My gut told me that this upside was huge and the price was so low it couldn’t go down. Well, I lost 70% on that investment. There is a reason why riskier investment is risky. If they proved to be dependable when it came to producing large returns they wouldn’t be considered risky. The more dependable they become the less risky. The former is no the characteristics of a risky investment. The words risky and dependable do not go together.

A risky investment will always include 3 things:

  • Higher expected returns
  • The possibility of lower returns
  • In some cases, a loss

If your prospective investment does not have these three characteristics, then it is not truly a risky investment. What can be dangerous is if you talk yourself into thinking a risky investment is safe when it most certainly is not. This self-destructive habit will be the cause of a lot of loss of money.

I want to make something clear, you’re not guaranteed anything. What I mean by this is just because you take a riskier pick you are not guaranteed to have a larger return. You are not guaranteed a large return because you might have taken some more risk than usual. I have fallen into this hole and I don’t want you to do the same.

Measuring Risk

Okay, its understood we need to make sure we pay attention to the risk amount in order to make a sound investment. Leaving risk out of an investment calculation is like leaving the peanut butter out of a PB&J. You just don’t do it. You don’t just forget about risk when deciding whether to invest or not.

Risk is like intrinsic value when it comes to measuring. It is extremely hard to put an exact number on it. But there are three things I want you to keep in mind when trying to calculate risk.

  • Risk is nothing but a matter of opinion. No matter what calculation you use or what guru told you the number. At the end of the day it is just an estimate so take every “Estimate” with a grain of salt.
  • You can not put a number on risk amount. Risk and intrinsic value are similar in the way that putting an exact number on it is close to impossible. Any given investment has two sides to it. The side that thinks the company is extremely risk and the other one that thinks its not. If you put everyone in a room and asked them their opinion on a certain company risk it would be impossible to get an exact number. The world is a complex place and trying to place an equation is impossible. Don’t take it from me though, listen to the godfather of value investing himself
    “the relation between different kinds of investments and the risk of loss is entirely too indefinite, and too variable with changing conditions, to permit of sound mathematical formulation.”- Benjamin Graham out of Security Analysis
  • Risk is deceptive. Common occurring events are easy to prepare for. But the once in a lifetime disasters are impossible to factor in. You never know what is going to happen until it does, it was close to impossible to prepare for what happened in 2008. In hindsight, we are able to see what went wrong but we would have never known if the crisis didn’t happen. No investment is completely safe. You can not plan for a black swan event.

The bottom line? Risk is so complex that it is close to impossible to measure it and put an exact number on it. There has been such an advancement in using higher math to somehow lower your portfolio risk. The problem is that life is not a quantitative thing. We have never been able to predict these catastrophic events with math so it is impossible to make a non-quantitative thing quantitative. If life was that simple, we would have averted every crisis.

So how do we measure something that is not measurable? If we can’t put an exact number on it how do we deal with it? At the end of the day, risk is an estimate and there are two things a skillful investor can use help to appropriately estimate risk:

First) The stability of value. When looking at this you have to look at the company in depth. Do you think there is more of a stability in Disney (DIS) or a newly listed company? Each company deserves a thorough look through. A stable company will have proved it to people by now. Look for stability in the company

Second) the relationship between price and value. This is the margin of safety argument. A certain investment can look attractive at one price but not at another. The best way to minimize your risk is to pay less. The larger you maintain the “margin of safety” the better off you are. Price is what you pay and value is what you get.

If you take these two things into account a skillful investor will be able to identify an estimate that can be applied to the investment. No matter how many formulas you use it will never be as good as a good investors judgment. The best way to become better at identifying risk is to learn more about companies. Look at what a good company looks like. Then look at what a risky company looks like. You will see major differences in the 10Ks. The best way to become a better investor is to learn more about what makes a good business and what makes a bad business bad.

I am sorry to disappoint you if you thought I was going to give you a simple formula to follow with some easy guidelines. The point I am trying to make with risk is that it is all relative. If we try to place a formula on identifying risk it will only be proven wrong in a matter of time. The world is so complex that we can not just slap an equation on it and say “You’re good to go!” that would be too easy and would leave us with limited success in the long term.

The best thing I can say is that you can use your better judgment when it comes to measuring risk. Don’t be afraid to call B.S. on something that doesn’t seem right. We as humans have a sense of what’s right and what’s wrong. You can easily tell what is riskier and what isn’t. Spending your days tirelessly trying to put an exact number on it is useless. Instead, go to the company’s 10-k and look at the risk factors section. If these are risks your willing to be involved in great but if at any point you stop and think to yourself “Well, that’s a pretty big deal.” Don’t be afraid to walk away and look elsewhere. There are so many companies in the public market that there is no reason for you to purchase what you don’t like.

You have the intuition to be able to identify what seems riskier than others. Don’t be afraid to trust your instincts. When a woman walks into a store you can tell right away with pretty good accuracy that they over or under the drinking age. Risk is a lot like the same thing. You know that Walmart is a safer investment than Snapchat. Don’t be afraid to use that common sense.

Grandpa’s Rule

This part is not in the book but I thought it deserved a place in this article. All of my life my grandfather has told me to always “Expect the unexpected”. This could not have more use than in the investment world. If something seems to good to be true it is. Whenever you see someone say this is a no lose investment be very skeptical. Trust me you can lose.

We as humans tend to think we have some uncanny ability to estimate the risk of something. The truth is risk is something that only lies in the future and we have no ability to predict the future. We expect the future to be like the present. It most likely will not be like that because changes are so rapid in many areas of life. If there is one thing we can count on is that the way we lived 50 years ago is way different than how we live now. There has never been a half-century without advancement and I strongly expect that trend to continue. If the thought “That is impossible, it will never happen.” It can and there is a good chance it might.

We know as humans not to grab a knife by blade or you will get cut. The problem is that when we have a market “that will never come down” people start grabbing the blade. They don’t just grab the blade with a few fingers, they begin to grab onto the blade with both hands as hard as you can. Before you know it, some will have two hands wrapped around a Samari sword. Then, when the thing that you were told would never happen does there is blood everywhere.

Risky investments can turn into net worth disasters. Mr. Market works in a funny way. See he tends to disguise risky investments making them seem less risky than they really are. You will see buy signs on Yahoo finance or a major analyst will have a positive opinion on them. These can be the worst because you will believe them. Then you invest and when the good times end you lose a lot of money. Risky investments are risky for a reason.

We tend to use the past as a measuring stick for the future. Laying out worse case scenarios like “worst that can happen, we have another crisis like 2008.” The problem is we don’t take into account the possibility that we could potentially run into something that is worse than the financial crisis. There is no clear-cut path to what the future will look like. But there is one thing we can be certain about; it will not look like that past.

In the end, expect the unexpected because it had a larger probability of happening than you think.

Understanding Risk Wrap Up

Out of everything we have learned so far here is what I truly want you to take away from this article.

  • Risk exists only in the future and its impossible to tell what the future holds for us. Obviously, when we look back in hindsight we can see where it was. Things that have happened, happened. The sad part is that we can look back and see a pattern but that doesn’t mean the process that creates outcomes is 100% dependable. There are many things that could have happened in the past that didn’t. by no means, however, entails they won’t happen in the future.
  • Decisions to bear risk are made with the likely events that occur, occurring. But once in a while, the skies will open up and the improbable will happen. Some of the time the impossible does occur.
  • People usually expect the future to be a lot like the past and largely underestimate the potential for change.
  • We can surround ourselves with the worst case scenario projections, the problem is they tend not to be negative enough. In the book, Howard tells his father story of the day at the Horse track. There was one horse in a race and Howard’s father put all of his money down on this horse. Well the horse, jumped over the fence and took off. Sometimes the worst case scenario means “the worst we have seen in the past”. There is no rule however stating the past is the worst that has happened. The future can potentially be worse.
  • People overestimate their ability to gauge risk and understand things they have never seen before. One of a human’s distinguishable traits from other mammals is that we don’t have to experience pain before we know something will hurt us. For example, we know not to touch a hot stove because we know it will burn us. During bullish times, people tend to forget this. Taking on major risk only to lose money when the good times end.
  • Lastly and importantly, the majority of people view risk-taking as a way to make money. Keeping in mind that bearing higher risk can generate higher returns. The market is a magician and has to make things look like this; if he didn’t people wouldn’t make risky investments. The problem is that when risky investments don’t work, they really do not work. After that happens people are reminded what risk is all about.

 

I really hope this opened your eyes to the other side of the investment process. Returns are nice but they come at a cost. Be sure to read the other parts of this risk series to fully understand what risk is all about. It will do nothing but help save you money.

Peace and Love,
Michael

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