Understanding Risk

Investing consists of dealing with the future. Thus, dealing with risk is an essential element in investing.

Steps in dealing with Risk:

• Step 1: Understanding it. 
• Step 2: Recognizing when it is high.
• Step 3: Controlling it.

Risk is an essential element. First in this section we will learn the first step to understand risk and other two steps we will cover in the next two following sections. 

Three powerful reasons that risk assessment is such an essential element of the investment process:

1. Risk is a bad thing, and most level-headed people want to avoid or minimize it.
2. When you are considering an investment, your decision should be a function of the risk entailed as well as the potential return. Because of their dislike for risk, investors have to be bribed with higher potential returns to take incremental risks.
3. When you consider investment results, the return means only so much by itself. The risk taken has to be accessed as well. Was the return achieved in safe investments or risky ones?

Defining Risk: 

The next major task is to define risk. What does risk involve?

This section is from the January 19, 2006 memo “Risk.”

Volatility is not necessarily risky. Risk is, first and foremost, the likelihood of losing money.

Aside from the risk of permanent loss of money. There are many other kinds of risks that you should be aware of because they can either affect you or affect others and present you with opportunities for profit.

Investment risk comes in many forms. Many risks matter to some investors but not to others. They may make a given investment seem safe for some and risky for others.

Other forms of risk:

• Falling short of one’s goal
• Underperformance
• Career risk (the extreme form of underperformance)
• Unconventionality
• Illiquidity

Falling Short of One’s Goal: 4% returns can be good for one type of investor while 6% returns could be terrible for another investor with different goals.

Underperformance: Failure to keep up with a benchmark index.

The best investors can have some of the greatest periods of underperformance. Specifically in crazy times disciplined investors willingly accept the risk of not taking enough risk to keep up.

Career Risk: Fund managers may not be concerned about gains but can be deathly afraid of losses that could cost them their jobs.

Unconventionality: Risk of being different.

Stewards of other people’s money can be more comfortable turning in average performance, regardless of where it stands in absolute terms, then with the possibility of being unconventional and getting fired.

Illiquidity: Being unable, when needed, to turn an investment into cash at a reasonable price.

What Gives Rise to the Risk of Loss?

1.The risk of loss does not necessarily stem from weak fundamentals.
2.Risk can be present even without weakness in the macro-environment.
3.Risk is deceptive.

Risk mostly comes down to psychology that is too positive, and thus prices that are too high.

Value investors believe high return and low risk can be achieved simultaneously by buying things for less than they are worth. In the same way, overpaying implies both low return and high risk.

How do investors measure risk?

1.It clearly is nothing but a matter of opinion.
2.The standard for quantification is nonexistent.

Everyone measures risks differently.

Skillful investors can get a sense of the risk present in a given situation. They make that judgment primarily based on the stability and dependability of value, and the relationship between price and value.

Investors who want some objective measure of risk-adjusted return can only look at the so-called Sharpe ratio.

How often in our business are people right for the wrong reason?

Nassim Taleb calls these people “lucky idiots” and in the short-term, it is hard to tell them apart from skilled investors.

Even after an investment has been closed out, it is impossible to tell how much risk it entailed.

Risk means more things can happen than will happen.

Risk is largely a matter of opinion.

Return alone, especially over short periods of time, says very little about the quality of investment decisions.