Category: Personal Finance

Where does the risk come from?

• Essentially, risk says we don’t know what’s going to happen. We walk every day into the unknown.
• There’s a range of outcomes and we we don’t know where the actual outcome is going to fall within that range. Often we don’t even know what the range is. – Peter Bernstein

How to think about risk probabilistically?

• Risk means more things can happen than will happen. – Elroy Dimson
• Even when you know the probabilities, that doesn’t mean you know what is going to happen. e.g. in Backgammon, you roll 2 dice and the possible outcomes of rolling two dice are represented in the table below. The number of total possible outcomes is 36.
  

  .	1	2	3	4	5	6
  1	(1, 1)	(1, 2)	(1, 3)	(1, 4)	(1, 5)	(1, 6)
  2	(2, 1)	(2, 2)	(2, 3)	(2, 4)	(2, 5)	(2, 6)
  3	(3, 1)	(3, 2)	(3, 3)	(3, 4)	(3, 5)	(3, 6)
  4	(4, 1)	(4, 2)	(4, 3)	(4, 4)	(4, 5)	(4, 6)
  5	(5, 1)	(5, 2)	(5, 3)	(5, 4)	(5, 5)	(5, 6)
  6	(6, 1)	(6, 2)	(6, 3)	(6, 4)	(6, 5)	(6, 6)

  
  Total of 7 can happen in 6 different combinations viz. (1 & 6, 2 & 5, 3 & 4, 4 & 3, 5 & 2, 6 & 1). Thus probability is 6/36 = 16.7% For combination total of 6, it is 5 possibilities out of 36, thus probability is 5/36 = 13.89% For total of 2, there is only 1 possibility (1 & 1) or total of 12 also has 1 possibility (6 & 6). Thus probability for these combinations is 1/36 i.e. ~3% and so on and so forth. Thus we know the probability for each combination (most likely, least likely etc.) In spite of this, we still don’t know what’s going to happen. Knowing the probability does not eliminate the uncertainty.
• Sometimes the expected value isn’t among the possibilities. e.g. Let’s say, the outcomes are 2, 4, 6, 8 and all are equally likely to happen i.e. each has 25% chance. So the people will bet on expected value as (2×0.25) + (4×0.25) + (6×0.25) + (8×0.25) = 5. But 5 is not even an outcome that can happen, so this is the fallacy of expected value.
• Another problem with expected value can be explained as below. Let’s say, outcome A) has higher expected value, but risk of total loss; and outcome B) has lower expected value, but no risk of total loss. In this case, we select outcome B) over outcome A) in spite of lower expected value.

What is the relationship between risk and asset quality?

Usually, it is assumed that high quality assets are less risky. People assume that large cap stocks are less risky than small cap stocks. But risk is NOT a function of asset quality.

• A high quality asset can be priced so high that it’s risky.
• On the other hand, a low-quality asset can be cheap enough to be safe.
• It’s not what you buy, it’s what you pay. Investment success doesn’t come from buying good things, but from buying things well.

To conclude, risk in investments is something that needs to be managed and controlled, not avoided.

Everyone knows that when investing, we must look at the risk. But have we ever paused for a moment and thought about it?

What exactly is risk?

Risk is the ultimate test of investor risk. The returns alone do not tell us how good a job the manager did. The key question to ask is how much risk did the manager bear to get that return.

Look at the following returns.

	Manager Returns	Market Returns
Manager 1	+10% to -10%	+10% to -10%
Manager 2	+20% to -20%	+10% to -10%
Manager 3	+5% to -5%	+10% to -10%
Manager 4	+15% to -10%	+10% to -10%
Manager 5	+10% to -5%	+10% to -10%

Say the stock market returns fluctuate between +10% to -10%.

• When we review this, we will find that there is no value added by Manager 1. It would be better just to buy an index fund.
• There is no value added by Manager 2 either. She/he is just very aggressive.
• Manager 3 also has no ability, just a lot of defensiveness.
• Manager 4 has performed good by beating the market, but it should be noted that it is extremely hard to get this performance consistently over a long period of time.
• Manager 5 is real value addition in my opinion, where the manager matches market performance (which is good enough) in good times and does slightly better than the overall market in bad times.

Is risk identified by volatility?

Risk is not volatility or day-to-day fluctuations in stock prices. But academics have adopted volatility as a measure of risk. That’s largely because volatility is readily quantifiable (measurable) and nothing else can measure risk easily.

So, in my opinion, volatility can be indicator of the presence of risk, but it is not risk itself. So what is risk actually? To quote Warren Buffett, risk is the probability of permanent loss of capital and/or inadequate returns.

This is very different than the Modern Portfolio Theory (MPT) which often measures risk using beta (how the investment moves relative to the overall market i.e. a reference benchmark) or standard deviation (how much a stock price moves up or down).

Is risk quantifiable in advance?

In my opinion, it is NOT. We cannot determine precisely ahead of time, how much risk is involved with any asset or any event? In fact, risk is non-quantifiable even after the fact. If you sell Rs. 100 investment for Rs. 200, even for this profitable investment, you can’t tell how much risky it was to invest or you just got lucky in terms of the outcome. Bottom line is that you it’s impossible to quantify risk in advance or even in hindsight.

What are other forms of risk?

• Possibility of loss is not the only risk.
• The risk of missing opportunity
• The risk of not taking enough risk

Which is a bigger mistake?

1. Buying it at the high end and seeing it decline?
2. Selling at the low and missing out on the recovery?

Clearly the answer is #2 above. Selling at the bottom is serious mistake in investment.

How do you manage risk?

There are only 4 ways to manage risk.

1. Avoid – If you want to travel from place A to place B, you can eliminate risk by avoiding to travel.
2. Reduce – If you are going to office in your car everyday, then you can take the car only twice a week and use public transport for remaining days.
3. Transfer – You can buy car insurance and health insurance to transfer the risk to an insurance company, which will cover the expenses in case of an accident.
4. Accept – Public transport like bus/train etc. or air travel is much safer than a car, but again, that is not 100% safe. So you just accept the risk and have to use those options.

So when buying any investment, don’t just focus on the performance or recent returns, but ask what kind of risk is involved? Is the fund investing in equity(stocks) or debt(bonds)? Is it Large-cap, Mid-cap, Small-cap etc? Is it domestic stocks or international stocks? Is it short term bond, intermediate term bond or long term bond?

I hope that this article was helpful to you.