Two views of risk 

In the context of investing, you hear the word on a daily basis. High or low-risk, risk on and off, risk tolerance, risk willingness, longevity risk, you name it. It is a single, simple word but can mean very different things to different people.

While risk can mean something different to everyone, it is a fundamental aspect of investing and one needs to understand not just what risk is but what risk means to the individual.

A Fund Managers’ View of Risk

• Underperforming their benchmark
• Underperforming their peers
• Having a poor risk-adjusted return (often measured by the Sharpe ratio). In other words, taking on too much risk for too little of a return.
• Volatility (stocks moving up and down too much)
• Underperforming in the short-term because if they can’t succeed quickly, they will get shut down and not have a chance to succeed over the long-term.

A fund manager likely has a view of risk that is the most relative of any type of group. In many cases, a fund or portfolio manager does not care about what a portfolio does but how it does relative to their peers and benchmark.

Risk to a manager is more mathematical than anything but almost ironically is the thing that can hold a fund back the most. If a fund is not allowed to invest longer-term where it can take over a year for an investment to work out, then this prioritization of short-term results over long-term results can really hold the compounding potential of a fund back.

Alternatively, if a manager is more focused on managing volatility and holdings in a way where they will not stray too far from a benchmark, they limit any ability to add real value to their investors. Some of the risks that a fund manager needs to manage can almost become a self-fulfilling prophecy. Worrying about short-term performance will almost certainly make you underperform.

An Individual Investors’ View of Risk

• Seeing their portfolio go down
• Not being able to retire and live a desired lifestyle
• Losing hard earned dollars to silly or speculative investments
• Making the wrong decision but thinking it was the right one

The final point is less an issue of being right or wrong and more an issue of simply being misinformed or not having complete information. In contrast to an investment manager, they are supposed to know what they are getting into and any investments they make are supposed to be done in such a way that they allow for themselves to be wrong or at least know that they will be wrong time and again and act accordingly.

An example could be a well-intentioned investor seeing a 5X P/E company with a nice yield and investing a large sum of money in the ‘no-brainer’ investment. On paper their thinking is right but others would likely look at the stock and see something bad in the works where the other shoe has yet to drop. This risk could also be categorized as ‘not knowing what you don’t know and not accepting that there are always things you don’t know’. I would think/hope that most full-time investment professionals know and have studied enough to catch a large degree of these pitfalls while being well aware that there is a real risk to each and every investment. 

It is interesting to see how differently a fund manager and an individual investor view risk. One is concerned with the outcomes while the other is concerned with data points and relative performance. I don’t know of any individual investors, even those that have a career in investing, that look at a personal portfolio and judge it based on the Sharpe ratio or compare their performance to a balanced benchmark.

An individual investor does not care that they outperformed a benchmark if their retirement portfolio is down 20% in a year. Now they have to work for another five years to make that back. That’s risk. An investment professional on the other hand could see their fund down 20% but if the benchmark is down 40%, they actually had a blowout year, and they would be right to ‘celebrate’ such a performance.

It is odd to think that two parties working toward the same outcome can view risk so differently. This is actually where advisors can play a big role. They can act as the bridge between the professional who is more focused on the stats and relative performance and the individual that needs to retire in 10 years. They are able to explain what a Sharpe ratio means to an individual and why holding a high volatility fund is ok in the context of a portfolio full of conservative funds. Most importantly, they can set a portfolio up and explain how a mix of assets gets an individual from point A to point B. Mind you, we are big proponents of DIY investing and taking some time on exercises such as understanding and defining risk, can go a long way in being a successful investor.

Here's what I define risk as:

1. Permanent loss of capital – You hear this one a lot and is often attributed to Charlie Munger. The word permanent is key. Any given day when investing, a loss of capital will occur. It is the bad investments or decisions that make that capital unrecoverable with reasonable probability that is a real risk. As an example, if someone owns a stock and it goes down 5%, something changes and you sell it. This is not a true permanent loss of capital. 5% and then some more can be made back with a high level of probability in a 10-year timeframe. Risk is when you have lost a sizable sum of money in nominal terms (i.e. it is hard to replace with income inflows in a reasonable time) and also lost a lot in percentage terms where the probabilities of making that money back in a finite amount of time is low.

A 50% loss on a $100 portfolio shouldn’t be a big deal. A 50% loss on a $500,000 portfolio is a big deal. An investor needs to save aggressively and also invest with strong returns to make back a loss like this. If you have less than a 10-year timeframe, an investor could risk a permanent loss of capital. This really is the ultimate risk and one we all face. It is the risk of not being able to provide for your loved ones and your retirement. All decisions need to be made in a way where the things that matter most aren’t put at risk of being lost.

How to mitigate this risk – There is no silver bullet but diversification is the best answer here. Diversifying by asset class, geographies, sector, style, and company size. All of these things help to ensure that a whole portfolio does not decline by a large amount in a short amount of time. It is no guarantee but likely the best defense.

Also, being more conservative as retirement or liquidation approaches is a key aspect of limiting this risk. If you have over 30-years of investing left, you can be more comfortable that any losses can be made back. If you have five-years until retirement, you won’t be able to bounce back from a 2008 type of crisis.

2. Throwing good money after bad – This relates a bit to the permanent loss of capital point but even worse than a permanent loss of capital, is increasing that loss on the way down. It reminds me of the idea that ‘if you liked it at $10, you’re going to love it at $5.’ A really big risk in my view is not realizing you were wrong and doubling down on a mistake. Even if you ride an investment on the way down, it should not be too bad in the context of a diversified portfolio. If position sizes are managed appropriately, it could go to zero and you should still be ok. It is when you have invested ‘X’ dollars and then average down with a multiple of the original investment only to realize it was a bad call when it was too late.

This brings what may have been an acceptable loss into one that might be unacceptable. So, while a permanent loss of capital is a big risk, an unnecessary loss of capital is even worse. Add to this the opportunity cost of doubling down on a bad investment plus the returns that money could have generated, and the compounded costs of this type of risk can be huge while also not being clear to an investor.

How to mitigate this risk – This is a tough one as an investor has obviously made an investment because they think it has potential. So, if it is cheaper, then why wouldn’t you want to buy more? I think the only answer to this is that an investor has their own personal process that makes sense to them. It might be simply to not average down, or to only reinvest X% of the original position, or maybe to add only when a technical indicator gives some sort of flag. The most difficult but likely most important way to mitigate this risk though is to first check yourself and make sure it has not become an emotional investment where you are no longer looking at the risks and only seeing ‘the obvious upside’.

3. Not having the right timeframe or patience for a thesis to play out – An investor can have the best idea or thesis out there but if they needed it to work in three years and it took five years, or more simply, they sold it too early, it was all for nothing. This is a big risk in terms of resources where you did the work and were right, but just did not set the right expectations or got so frustrated/bored with a name that you left it and went elsewhere.

There are also two sides to this risk. The first is that you miss out on a good return due to a lack of patience. The second is that you have likely reinvested these funds elsewhere and need that investment to work out as well. Missing out on good gains from an investment sold and buying into another investment that declines is a major opportunity cost and risk. Of course, there is a fine line here. Sometimes an investor needs to cut and run and accept that they may have had the investment wrong or that the time for something to unfold is simply too long in the future or too uncertain.

How to mitigate this risk – Dividends are a great way to mitigate this as dividend payers reward an investor for waiting. If the yield is appropriate, many investors can be comfortable with holding a dividend payer for ten years, waiting for a thesis to play out and not get antsy. This, of course, does not mean a portfolio should only contain dividend payers, but those cash flows will make waiting for the longer-term investments just a bit more bearable.

The other way to mitigate this is to simply set realistic expectations ahead of time. Companies do not turn on a dime and strategies and capital investments take time to play out as do acquisitions. If a timeframe is less than a year, it is too short for a long-term big winner in a portfolio. We often suggest an investor take a 3-year outlook minimum when considering an investment.

4. Simply not seeing a risk that should have been obvious – While this is less excusable for an investment professional, it will no doubt still happen no matter how good, bad or lucky you are. Volatility and losses are a risk that need to be understood and embraced when investing. Every investor knows that far less than 100% of their investments will work out and that to have a few big winners, a few big risks need to be taken. 

This is all acceptable if you understand the risk and see the potential downsides as well as accepting what you do not or cannot know. What I am referring to with this risk are the items that you probably should have caught, were warned about and ignored, or something you just outright missed. This is a risk because it is something that could have or should have been avoided. Over the long-term, mistakes like this will undoubtedly occur multiple times but to me, this is a very real risk. I am ‘ok’ if a stock declines by 20% because they missed a short-term quarterly report or if a macro-event occurs. I am less ok with this error if there was a clear bearish case against a company with a huge short position on the shares or the company was carrying way too much debt and not covering interest payments. These mistakes are more obvious in hindsight in every case and the most painful to look back at.

How to mitigate this risk – All the due diligence in the world is unlikely to prevent mistakes like this. So being ‘easy’ on yourself and accepting that many times the market will make you look like a fool is a good place to start. The key is to learn from the mistake. Otherwise, process can be important here such as setting appropriate position sizes and having limits on things like leverage a company holds in a portfolio.

Exceptions to the rule can apply, but at least then you know that ‘I typically do not invest in a company with 3X leverage and understand that it might blow up, but I am ok with the risk-reward trade-off here and understand it’. Again, it is having the risk become a reality without addressing it and accepting it that is the real problem here.

The other way to mitigate this is to never assume you are smarter than the market and to not think ‘they’ have it totally wrong. This can and does happen but likely much less than one thinks. If someone is investing in a stock and saying, the market has this totally wrong, you might just be ignoring one of those risks you could have avoided.

5. Being too emotionally invested in an idea and not knowing it – This is something you see a lot with investing. Many individuals, professional and non-professional alike, stake so much of their reputation or energy on an investment that they make it too difficult to ever change an opinion or view. The research goes down a dark path where an investor only seeks sources that agree with their thesis and ignores all others. 

This is a real risk both because it can occur subconsciously with no awareness but also because it leads to bad decisions being made. There are also some real reputational risks with this as well. People can be wrong on an investment; most rational investors get this and expect it. However, when you are continually beating the drum on a thesis or idea year after year and are wrong year after year, it begins to reveal that an individual may just be a bit too emotionally invested in the idea.

What’s worse, is that they don’t even see it and begin to come across as a broken record. You even see this with the best of investors that should know better and a lot when individuals are talking about macro-economic data. An economy can be putting up the best jobs numbers ever, month after month and some will find the most minute, inconsequential and tedious of details and point to that as if it negates the tsunami of positive data facing them down. Eventually, they will be correct, but the risks of both losses from avoiding/missing a good investment and risks to reputation can be enormous.

How to mitigate this risk – If you find yourself thinking that everyone else is an idiot when making an investment and they ‘just don’t get it’, you may be too emotionally invested. Also, if you find yourself talking about it non-stop or losing sleep over it, this is likely a symptom. The solution, of course, is appropriate position sizing (it may be too big, causing you to be more emotional with it) and probably not getting so worked up about a thesis that you back yourself into a corner and can never change an opinion.

Changing a view and admitting you are wrong, in anything, is very difficult. But if this is a risk you cannot catch and manage when investing and in life, you’re going to have a lot more problems to deal with, starting with very high blood pressure most likely.

That’s my take on risk. I am ok with volatility as long as I understand that there will be some. What I view as real risks are the things I should know better than to do but do them anyway, and the bad things I am doing but am not consciously aware of.

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