As a lover of film, The Godfather trilogy is my all time favourite. In Godfather 2, after Michael Corleone escaped an assassination attempt by his family’s long term business partner, Hyman Roth. Instead of waging an immediate revenge, he ordered his family solider Frank Pentangeli to make good with Hyman Roth. In his late father’s study room, Michael explained to a confused Frank, “My father tough me many things in this room. He taught me keep your friends close, your enemies closer.” This line has stuck with me forever since. It’s simple yet profound. It implies the importance of getting to know and getting on top of your worst fears.
Risk is the essence of investment, yet it is a widely misunderstood "enemy". In this article, I try to argue that what is and is not risk. Also why risk is so important to investors and to a healthy investment eco system.
The evil twin
In investments, everyone likes to talk about the return of an investment. What’s usually got left out of the weekend BBQ talk was the “evil twin” of return, risk. It’s the enemy that most people like to avoid but best investors like to keep them “closer”. Like the founder of Oaktree Capital, Howard Marks said in his book The Most Important Thing,
Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable…dealing with risk is an essential element in investing.
Despite its importance, risk is the most misunderstood concept, or the most debated concept in investment industry. The most widely adopted risk measures in the financial industry are flawed and misleading. Volatility and Value At Risk (VaR) are two widely recognised risk measures that underlies most of the investment and risk management models today.
Volatility, driving with the rear-view mirror
Volatility, as a measure of risk is the building foundation of the Modern Portfolio Theory (MPT) that is so entrenched in the world of finance. It’s typically defined as standard deviation or variance of the returns. Use it as a proxy to risk is both inadequate and misleading.
Harry Markowitz came up with the MPT in the 1950s, at a time when investment selection was made in the hands of select professionals who would sit around a table in a smoke-filled board room, picking investments based on their experience and intuitions. Harry astonished the world with the elegance of simple mathematical equation that promised to reduce risks without sacrificing expected portfolio returns through diversification.
It was so simple and powerful, Sam Savage, a consulting professor at Stanford University equates what Harry did for portfolio management to what Wright brothers did for aviation. For the first time, investment selection became scientific and can be published in respected journals because Harry gave risk a quantifiable definition. Today, if you are using a robo-advisor, or for that matter a human one, you are using a strategy that is based on a version of MPT. It was everything you need to systemise investment process, what could go wrong?
Quite a lot, it turns out. MPT, like all quant models in finance, it’s only as good as the underlying assumptions. One of its more problematic assumptions is that we can estimate the expected risk and reward for each stock in the first place. By estimating the expected returns, we are making a forecast of the future. When we measure the risk, it's the forecast of the uncertainty of our forecasts, which is very difficult and with low degree of accuracy.
Volatility as a risk measure tells us about the past fluctuation but it's no way constant. Risks don't express itself through volatility. If a drug company is waiting for a FDA approval, its stock price can be very stable leading up to the event, which says nothing about the future risk of uncertainty.
More shots of risk, anyone?
What came after the MPT is the Capital Market Line. It gives rise to the graph below.
Source: Howard Marks, Oaktree Capital Management
It implies that positive relationship between risk and return. Its profound implication is that people start to discuss risk-adjusted returns, rather than just returns. It started to put price on risk, it’s called “market price of risk”. It looks like science has again saved the day by bringing more clarity to a complex world.
Then people started to wrongly interpret the graph. Phrases like “lower risk, lower return; higher risk higher return” and “if you want to generate more return, you have to take on more risks” started to become the guiding principle for a lot of people. More astute investors would ask themselves, if risky investments can be counted on to produce higher returns, why would it be risky in the first place? Others would just keep taking on higher risks with the unfounded reliance on them to generate higher returns. These investments usually end in tears. So, what has been overlooked here? The wise Howard Marks has made a brilliant adjustment to the previous graph and it makes much more sense.
Source: Howard Marks, Oaktree Capital Management
In his 2014 memo to investors, he remarked:
This is the essence of investment risk. Risky investments are those where investors are less secured regarding the eventual outcome of the investment and face the possibilities of faring worse than those who stick to safer investments, and even of losing of money. The investments are undertaken because expected return is higher. But things could happen other than that which is hoped for. Some are superior to expected return and others are decidedly unattractive.
As one ventures out to the right side of the curve, the expected return is higher, so are the possibilities and severities of undesirable outcomes, represented by the wider bell curves. If nothing else, I wish readers can remember these two graphs that represent the nature of investment risks.
So, the worst outcome is what we are trying to guard against. Then let’s find it and bring it under our watch. Sure that can tame the beast.
VaR, a 95% bullet proof bodyguard vest?
The investment community invented another risk measure, Value At Risk (VaR). It measures the biggest drawdown a portfolio can experience under 99% of the situation. This metric is largely used by the regulators to monitor banking system’s capitalisation adequacy.
This metric is very badly understood. It doesn’t measure the maximum likely loss, but it actually measures the minimum loss, according to Shroders’ Alan Brown. It’s based on the assumption that the market follows a normal distribution, when in reality the market tends to follow a power-law distribution which is characterised by extreme events and burst of intense volatilities.
VaR can also be gamed. A trader can design a trading strategy that conceals explosive risks in the 1% tail that is excluded from the 99% confidence interval measure. For example, if I offer you an odds of 127-1 for betting $100 that the head will come up 7 times in a row in a coin flip game. If you accept the odds and bet on it, my chance of winning is 99.2%. So on a 99% threshold, my VaR is zero. But it says nothing about my potential exposure of a $12,700 loss. In fact, using VaR as a risk management metric is like buying a car with an airbag that is guaranteed to fail just when you need it, or replying on a body vest that keeps out 95% of the bullets. It cuts off the very part of the distribution of returns that we should worry about the most, the tails.
Volatility: A snake that eats its own tail
Regardless of volatility or VaR, they all assume that we act alone. In fact, the market all largely use the same model. This creates systematic risk that results in everyone doing the same thing when they are panic, running for the exit. Whenever a model is too popular, it influences the market and renders itself unstable. It's what George Soros called "reflexivity". It creates a snake that eats its own tail.
Source: Volatility and the Alchemy of Risk, Artemis Capital Management 2018
Permanent capital impairment
The main risk in investment is not volatility, it is the possibility of permanent loss. The problem is that the probability of a permanent loss is no more measurable than the probability of rain. It can be modelled, estimated, but it can’t be known.
Risks are multi-faceted. That permanent loss can come from four dimensions:
Valuation Risk, buying an over-valued asset. 2000s tech bubble and the recent Nasdaq’s demise should be fresh reminders of that risk. This risk doesn’t only apply to equity assets, it’s the same for the bonds and credit investments. Any long only assets can be priced as expected cashflows divided by a discount rate that reflects the risk-free rate and some risk premium. The GFC and recent pandemic brought the discount rates to its historical lows. That made everything look historically rich in valuation. But this slow growth, low inflation and low rate environment will not last. It will fundamentally change the valuation. Looking forward investors should expect headwind from the valuation downgrades.
Fundamental or real business risks, the investment’s fundamentals were not as sound as you expected. Structural change can also be weakening the effectiveness of the fundamental analysis. This risk is certain true during a persistent shift from a physical world to a digital world and many companies and business models will be disrupted along the way.
Financing risks, applying too much leverage. Leverage can never turn a bad investment good. But it sure can turn a good investment into a bad one by forcing you to realise your loss at the wrong point in time. It turns a temporary capital impairment into a permanent one. When excessive leverage combines with illiquidity, disastrous outcome is almost inevitable. That was essentially what happened to Long Term Capital Management’s collapse in 1994 and the subprime mortgage crisis of 2008.
Liquidity risk. This is another risk that will turn temporary fluctuation into a permanent loss. This might come from poor investment planning by bearing too much illiquid assets. Investors and institutions that held a lot of illiquid assets suffered considerably in the crisis of 2008. During the time of distress, usually those assets are being sold at the same time. Some assets can’t be sold in time to meet financial exigency. Others will have to be sold at a heft discount. That created tremendous opportunities for prudent and patient investors who can acquire assets at a very healthy margin of safety.
In the process of mitigating a particular risk, you will inevitably pick up some other risks. For example, in order to avoid fundamental risks, you tend to invest in more mature and high-quality companies. That increases the valuation risk that is inherent in those investments. That’s why, investment is simple, but not easy. Every participant in the investment process should apply experience, judgement, and knowledge of the underlying investment.
There are many other risks out there, like event risk, credit risk, concentration risk, over-diversification risk and career risks. But I believe if investors just focus on the four major risks that lead to permanent capital loss mentioned here, they would do considerably better.
Ignore investment risk: Swimming naked like cavemen
Risk aversion is the most widely observed behaviour in animal kingdom. It must confer some evolutionary advantages. It’s also the most fundamental property of the human behaviour. The irony is that human is also an extraordinarily optimistic specie. If you were a pessimistic caveman, you would never be bothered to go out and hunt for the mammoth that is 50 times your size. You and your offspring would have died out pretty soon. But that optimism is not very good strategy in investment.
Risk aversion is what keeps the investment eco system safe. For investors who are risk averse, they demand compensation for bearing risks. That makes perfect sense in investment. That’s what keeps the steepness of the slope in the risk-reward line in the previous graph. For every incremental risk, investors will ask for reasonable risk premium. Investors conduct more due diligence, apply conservative assumptions, and have a healthy dose of scepticism to investment propositions. That’s what keep the valuations of the risky investments in check.
When people become too exuberant and overly optimistic, they extrapolate short term outperformance far into the future. The fear of missing return opportunities outweighs the fear of losing capital. They don’t ask for risk premiums when taking on risks and happily accept frothy valuations. They ignore the market cycle and convince themselves that “this time is different”. When risk tolerance is widespread after a period of benign market environment, that’s when the systematic risk is at its highest. Only when the tide goes out, you find who’s swimming naked.
Conclusion
I hope this very simplistic overview of risks can help investors to avoid some worst investment outcomes. Compared to volatility, permanent impairment of capital is far more meaningful to investors and closer to investment reality. Investor should be risk aware and exercise caution when there lacks attractively priced assets that will give you the margin of safety. Don’t join the party because everyone else is dancing to the music, only to find that you are swimming naked when the tide goes out.
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