Risk in a changing world
Most individual investors are a bit intimidated by the idea of risk. They want good returns but they want to avoid risk. I think risk is one of the most misunderstood concepts in investing. Risk in my Oxford dictionary is defined as the ‘chance of loss or a bad consequence’.
This post is about three words: risk, uncertainty and diversification.
To my way of thinking, the ‘risk’ in a well-constructed equity portfolio is at heart the broad variety of business and economic ‘risks’ to the underlying businesses of the companies that make up the portfolio. These ‘risks’ can undermine the intrinsic value of the underlying businesses and ultimately impact the market prices of the stocks in the portfolio. This can lead to bad consequences.
Risk and uncertainty
But we need to think carefully about how I have used the word ‘risk’ in the previous paragraph. In fact ‘risk’ may not be the best word to describe business and economic ‘risks’.
The best known investment book on risk is Peter Bernstein’s Against the Gods, the Remarkable Story of Risk published in 1996. He says that the theory of probability is “the mathematical heart of the concept of risk”. (Bernstein, 1996) p3. (emphasis added) That is, he is saying ‘risk’ is capable of being tamed by mathematics and that central to risk management is probabilities calculated using mathematics.
The reality is that there are many ‘risks’ that are not susceptible to mathematical analysis. Business and economic risks are probably better described as ‘uncertainties’.
In Animal Spirits, Akerlof and Shiller write: “Businesspeople make decisions with fundamental uncertainty about the future. Risk, Uncertainty and Profit, written by Chicago’s Frank Knight in 1921, is today regarded as a classic. Knight made a distinction between economists’ concept of risk and the different sort of uncertainty in almost all business decisions. Risk, he said, refers to something that can be measured by mathematical probabilities. In contrast, uncertainty refers to something that cannot be measured because there are no objective standards to express probabilities.” (Akerlof & Shiller, 2009) p144. (emphasis added)
So, the thought from Bernstein, Knight, Akerlof and Shiller is that the word ‘risk’ should be confined to something where probabilities can be calculated. ‘Uncertainty’ on the other hand is where you can’t calculate probabilities. In this post I would like to work with that distinction.
Risk Management, Modern Portfolio Theory and CAPM
Readers can read lightly through the next three paragraphs. There will be no exam questions on MPT and CAPM.
Bernstein tells us that professional risk management really only emerged in the 1970s. (Bernstein, 1996) p301. And the first big push in risk management was mathematically derived models of diversification. The investment world seized upon the work of Harry Markowitz who is thought to have shown that investment returns could be optimized for a given level of risk through diversification. With charts and formulas and lots of math he studied risk, return, correlation and diversification.
From this evolved Modern Portfolio Theory (MPT) which says that you can eliminate the peculiar risk of any security by holding a diversified portfolio – that is, it formalizes the folk slogan ‘don’t put all your eggs in one basket.’ The risk that is left over is the only risk for which investors will be compensated, the story goes. This leftover risk can be measured by a simple mathematical term – called beta – that shows how volatile the security is compared to the market.
In the same era the Capital Asset Pricing Model (CAPM) was created and is the basic model academics and Wall Street have been using since. It asserts that stock betas are positively correlated to returns. A further tenet of the CAPM is that volatility is a measure of risk and, thus, if you want a higher return you have to invest in more volatile stocks, i.e. riskier stocks. CAPM may be called the standard risk/return model.
The problem with MPT and CAPM for risk management is that they can’t cope with uncertainty. Furthermore, it turns out that volatility is not a good proxy for risk.
Bernstein concludes: “Although [MPT and CAPM modelled] diversification has never lost its importance, professional investor recognized some time ago that it was both inadequate as a risk-management technique and too primitive for the new environment of volatility and uncertainty.” (Bernstein, 1996) p301.
Let’s tease out further the idea of uncertainty. It wasn’t that there was more volatility and more uncertainty. The problem was that the mathematical models were inadequate.
Bernstein references Keynes views written in 1937: “By ‘uncertain’ knowledge… I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty… the sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention…About these matters, there is no scientific basis on which to form any calculable probability whatever. We simply do not know!” (Bernstein, 1996) p229. (emphasis added)
We can put that in a modern context. From the perspective of the year 2005, the prospect of a major global financial crisis was uncertain. From the perspective of 2019 the prospect of a global pandemic was uncertain. At all times, the prospects for business and the economy are uncertain. That is, we have no ‘scientific basis on which to form any calculable probability whatsoever’.
Uncertainty permeates investing. The comfort for the individual investor is that professional investors operate under the same debilitating conditions. The playing field is more level than one might expect. Professionals do not have the welters of precise information and high level analysis many individuals think. Their mathematical models give them precise answers and that is the problem. As Maynard Keynes has said, it is better to be vaguely right than precisely wrong.
So what is the individual investor to do? I would say the main thing is to have a sound investment process. Ben Graham would call it having ‘sound principles of operation’. In a speech in 1974 Graham remarked that investing did not require genius: “What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.” (emphasis added)
On the subject of diversification, I have noted the particular importance of understanding business correlation, not price correlation. Tools that show which stock prices have lower correlation with others are not a sound basis to achieve diversification. What is needed is balance, natural hedging and the idea of building a team of stocks that works together. I explain in a post. See here.
The bottom line is that ultimately one is trying to create a portfolio of superb companies that is diversified and balanced that was purchased with a margin of safety.
To read further about risk and uncertainty readers can go to Chapter 4. Risk and Uncertainty of the Motherlode.
That chapter contains the following sections:
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Click here for the Motherlode – introduction
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