Risk is most frequently referred to as the amount of exposure to the potential of unfavorable outcomes from an investment.
Naturally, there is no such thing as a surefire investment in life – Every investment comes with some probability of failure. Even the Treasury Bills are not strictly risk-free. In fact, governments have defaulted on their loans throughout history. For example, when Greece adopted the Euro as its currency in 2008, the government caved under massive economic instability and ultimately failed to pay off its sovereign debt.
Is it possible to take no risk?
In a nutshell, the key question is not whether an investment involves risk but rather how much. Risk pervades our daily lives – Facing risk is inevitable, but we can come to a better understanding by quantifying it. For example, for a typical individual, the odds of getting struck by lightning is less than one in a million. Meanwhile, the odds of being attacked by a terrorist while out vacationing is 1 in 1.6 million.
Even in the face of this, individuals take risks in such basic situations as commuting to work or going to the supermarket, simply because the probabilities, once considered, are small enough to warrant undertaking.
It would be misguided to avoid any risk at any cost in one’s financial life. Rather, the intelligent investor seeks opportunities with minimal risk but satisfactory expected returns. Needless to say, intelligent investing involves cultivating a strong familiarity with the concept of probability as well as a realistic recognition of risk.
Identifying assets with low downside probabilities accompanied by great upside potential is what intelligent investing is all about. When it comes to investing, any discussion of risk that does not take into account expected returns is incomplete, and vice versa. For example, many believe that investing in treasury bonds is a safe bet as it comes with a 4.1% yield, most often misleadingly invoked in the industry as the “risk-free” rate. However, one can overlook the fact that by investing in treasury bills one is losing money to inflation, which currently stands at over 8.2%. Is volatility risk?
Wall Street is obsessed with volatility (the short-term fluctuations in market value of any asset or equity) and often misconstrues volatility as risk, but in reality volatility simply represents an asset's market value around its average return. By extension, the standard deviation, which indicates how closely a stock's price is clustered around the mean or moving average, can be used to gauge volatility.
To calculate the standard deviation, one first collects data about the asset’s market value at different points in time. One then calculates the mean or moving average of these values, which is then subtracted off each individual market value. Each result is thereafter squared and comprehensively summed. Now, we have arrived at the total squared difference from the mean from all the observed values. To find the average level of deviation from the mean, the total squared difference is divided by the total number of data points observed and then squared to yield the final standard deviation of the market value.
Thus, volatility is not necessarily a risk. It simply represents the fluctuation of stock prices around their mean values. It gives no clue as to the level of exposure the investor has toward unfavorable business outcomes. Simply put, it provides no information about the fundamental value of the business.
Higher volatility indicates great upside opportunities, opening the door for investors to buy high-quality assets at low prices.
To better explain our reasoning, consider this example: You’re in Manhattan looking to buy a skyscraper worth $500M, rented to tenants with AAA+ ratings. It generates $50M in profits per year, and the rent is growing 8.26% annually, in tandem with inflation. On this particular day, there is news in the market about a new Covid-19 surge, causing the market value of the skyscraper to fall to $250M.
News like this changes on a daily basis, which can impact the sentiments of the market. This can lead to extended periods of general optimism or pessimism. However, given that New York is the world’s financial center, where the majority of global financial firms are headquartered, a permanent decline in the demand for office buildings is extremely unlikely and does not affect the underlying fundamental value when one takes the long view.
In this scenario, volatility helps us to exploit opportunities like buying a skyscraper that is really worth $500m for $250m. These forces lead to what is called the margin of safety, the difference between the intrinsic value and the market value. Buying things cheap allows one to achieve asymmetric risk and reward in our investments. Ironically, when it comes to value investing, the optimal time for buying is created when the market is perceived as dreary or unattractive.
Reckoning with Uncertainty
The final key theme revolves around the importance of understanding uncertainty. We should consider the future, broadly defined, as a spectrum of possibilities rather than a single outcome from a given set of potential scenarios. We must be flexible enough to fully encapsulate all the possibilities and define their relative likelihood, instead of focusing simply on the ones that are most likely to occur. Some of the most significant losses in history occurred when investors dismissed seemingly impossible outcomes.
Meanwhile, the risk is often confused with uncertainty. Granted, both risk and uncertainty are to be expected from any undertaking; however, risk and uncertainty are not the same things. There could be very high uncertainty but little risk.
For example, imagine Company A has a recurring average net income of $200m, but this figure fluctuates unpredictably from year to year. For example, it earned $600m in 2018, $120m in 2019, $200m in 2020, and $80m in 2021. From the analysts’ perspective, there is a lot of uncertainty in the level of net income as the exact figures cannot be predicted on a yearly basis.
Suppose the CEO of Company A offers to sell the company for $200m, would it be an attractive buy? Even if the investor cannot identify a consistent pattern in Company A’s net income, buying the company at $200m would surely still be a bargain. In this case, it is said that Company A has a lot of uncertainty from the variation in income, but not as much risk because the business is reasonably expected to generate a minimum of $200m in annual income over the long run.
Figure 2: Uncertainty in earnings of Company A
To summarize, investments are comparable to other undertakings in life in the sense that they always involve some level of risk. Common experience dictates that to achieve anything one must be willing to take healthy risks and become philosophical about adverse outcomes. The astute investor therefore must not shy away from risk; rather, he is able to see through the noise of the uncertainty to arrive at an approximate risk-return profile of the asset and seize attractive opportunities when the odds are overwhelmingly in his favor.
By: Siddharth Singhai
This White Paper expresses the views of the author as of the date indicated and such views are subject to change without notice. Ironhold Capital has no duty or obligation to update the information contained herein. Further, Ironhold makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
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