The title might sound trivial but as Joe Wiggins, who writes about behavioural aspects of investing, writes in this blog, most of us don’t understand what we mean by risk. As he puts it, jumping from a tall sky-scraper with no parachute is not risky – as the outcome is certain, in this case death. Understanding risk this way, especially in the context of investing, an inherently probabilistic field is important.
“Perhaps Elroy Dimson put it best, and most succinctly, when he said: “Risk means more things can happen than will happen.”
This definition gets to the core of how investors should consider risk. Risk is an absence of certainty. Risky situations are defined by there being a range of potential future outcomes and some unknowable probability attached to those outcomes.
Imagine if I make a parachute from items I found around my house and then proceed to jump from the top of the tallest building in the world – this is an extremely high risk decision with the range of outcomes as wide as you could get (I live – unlikely, I die – probably).
Alternatively, if I decide to simply jump from the top of that same tall building (absent homemade parachute) that wouldn’t be a risky decision because the result is certain (or close enough to it). Choices are not risky because they are bad, but because the consequence of them is uncertain.”
He then talks about how to deal with uncertainty when it comes to your investments. For example, longer time horizons in equities tend to reduce the range of outcomes and hence reduce risk.
More importantly, he highlights diversification: “It works because by combining securities and assets with different future potential return paths it significantly constrains the range of outcomes of the combined portfolio.
.. Diversification is a tool whereby we can (very imperfectly) create a portfolio with a range of potential outcomes that we are comfortable with. When individuals complain about over-diversification, what they typically mean is that the range of outcomes has been narrowed so that average outcomes are very likely. There is, however, no right or wrong level, it simply depends on our tolerance for risk. Or, to put it another way, our appetite for extremely good or extremely bad results.”
If you are interested in understanding the importance of diversifying across uncorrelated asset classes, you might want to check out our recent webinar on the subject.
Finally, Wiggins talks about how despite understanding risk this way, we might get it wrong:
“Risk management often goes wrong and it does so both behaviourally and technically. Behaviourally, because we have a plethora of biases – extrapolation, overconfidence, availability, recency etc – which mean we worry about the wrong things and are complacent about issues that should matter. Technically, because we try to precisely measure things where it is impossible to do so – inevitably becoming overly reliant on inherently limited metrics. If we use a single number to measure risk, we are not thinking about risk in the right way.
We don’t know much about the future, but we know more things can happen than will happen. We should invest with this in mind.”
From an asset manager’s perspective, margin of safety on valuation, that allows for a range of outcomes on the underlying business is perhaps the best risk management tool.
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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.
