Understanding what risk really is.

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by dipsis

I’ve spent more time than I care to admit battling online poorly conceived notions of risk in investing. Below are excerpts from Howard Mark’s book, The Most Important Thing. This will probably fly in the face of many redditors, especially those who laugh at the idea of diversifying their portfolio into bonds or international equity. I hope this can create an informative discussion on risk for us.

“Especially in good times, far too many people can be overheard saying, ‘Riskier investments provide higher returns. If you want to make more money, the answer is to take more risk.’ But riskier investments absolutely cannot be counted on to deliver higher returns. Why not? It’s simple: if riskier investments reliably produced higher returns, they wouldn’t be riskier!

What people think of the risk return relationship

But here is a realistic risk and return graph

It is my view that – knowingly or unknowingly – academicians settled on volatility as the proxy for risk as a matter of convenience. They needed a number for their calculations that was objective and could be ascertained historically and extrapolated into the future. Volatility fits the bill, and most of the other types of risk do not. The problem with all of this, however, is that I just don’t think volatility is the risk most investors care about. I’ve never heard anyone at Oaktree – or anywhere else, for that matter, say, ‘I won’t buy it, because its price might show big fluctuations,’ or ‘I won’t buy it, because it might have a down quarter.” Thus, it’s hard for me to believe volatility is the risk investors factor in when setting prices or prospective returns. Rather than volatility, I think people decline to make investments primarily because they’re worried about a loss of capital or an unacceptably low return. To me, ‘I need more upside potential because I’m afraid I could lose money’ makes an awful lot more sense than ‘I need more upside potential because I’m afraid the price may fluctuate.’ No I’m sure ‘risk’ is – first and foremost – the likelihood of losing money.”

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“The risk-is-gone myth is one of the most dangerous sources of risk, and a major contributor to any bubble. At the extreme of the pendulum’s upswing, the belief that risk is low and that the investment in questions is sure to produce intoxicates the herd and causes its members to forget caution, worry and fear of loss, and instead to obsess about the risk of missing opportunity.

Where do we stand today [mid-2007]? In my opinion, there’s little mystery. I see low levels of skepticism, fear and risk aversion. Most people are willing to undertake risky investments, often because the promised returns from traditional, safe investments seem so meager. This is true even though the lack of interest in safe investments and the acceptance of risky investments have rendered the slop of risk/return line quite flat. Risk premiums are generally the skimpiest I’ve ever seen, but few people are responding by refusing to accept incremental risk…

The truth is, the herd is wrong about risk at least as often as it is about return. A broad consensus that something’s too hot to handle is almost always wrong. Usually it’s the opposite that’s true. I’m firmly convinced that investment risk resides most where it is least perceived, and vice versa. When everyone believes something is risky, unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price. And, of course, as demonstrated by the experience of the Nifty Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risk. No risk is feared, and thus no reward for bearing – no ‘risk premium’ – is demanded or provided. That can make the thing that’s most esteemed the riskiest. This paradox exists because most investors think quality as opposed to price is the determinant of whether something’s risky. but high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them… Elevated popular opinion, then, isn’t just the source of low potential return, but also of high risk.

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In short, in bull markets – usually when things have been going well for a while – people tend to say, ‘Risk is my friend. The more risk I take, the greater my return will be. I’d like more risk, please.’ The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so…and risk compensation will disappear.”


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