Returns, returns and more returns. If you have been following the financial media and analyst reports very closely and blindly, it is likely that your stock research might have been influenced to be upside-biased. The finance industry places a disproportionate emphasis on investment returns rather than investment risk.
However, we have greater control over the risks we take than the returns we chase. Hence, our first concern should always be risk management and not investment returns.
If we can take care of our downside, the upside will naturally take care of itself.
Now let us explore how experts and academics in the finance industry view investment risk. We will first talk about the concept of volatility in the stock market, followed by the application of volatility in finance and lastly, how value investors should approach investment risk. Hopefully, this will give you a good idea of the contrast between how value investors view risk and how others view risk.
Two types of investment risk
Investment risk can be viewed in two forms, volatility and uncertainty. Volatility is the dispersion of stock returns while uncertainty is the probability of events occurring. By zooming straight into volatility, we are assuming that we know the dispersion of the stock returns and this is largely applicable only in the short run. Analyzing the uncertainty of an investment will provide a more appropriate picture of risk for the investor with a value investing mindset.
Volatility as risk
Volatility is widely viewed as an equivalent to risk as it is easily quantifiable and can be incorporated into fancy mathematical formulas and complex models. In academia, the variability of the stock return is seen as a proxy for risk.
Assuming Company A has a stock price that fluctuates 6% every other day, it is seen to be a whole lot riskier than Company B with stock prices that may barely moves, even if Company B is on the brink of bankruptcy. Hence, while academics believe that volatility of the stock price will incorporate information about the economics of the company, very often these characteristics do not present themselves through the volatility of the share prices.
However, this is not to say that volatility as a risk measurement is absolutely flawed. As shared by Michael Mauboussin, Director of Research at BlueMountain Capital Management, the most suitable measurement of risk is largely dependent on your time horizon. For example, if you are a trader using leverage, you will be extremely concerned about the volatility of the prices as fluctuation of your capital will directly impact your trading losses and profits over the next few days.
So how do value investors measure risk?
On the other hand, if you are a value investor with a long-term horizon, it does not make sense to view volatility as risk. As value investors, when we see our stocks decline after our purchase in the short-term, we have the control to resist any temptation to sell.
Furthermore, with volatility it would provide great investment opportunities for value investors. It is during volatile times, when good solid companies may get oversold; hence, creating an opening for us to enter the market.
The risk which value investors are usually concerned about would be the risk of a permanent loss of capital – uncertainty. The analysis of risk should not be viewed as a separate task from the analysis of intrinsic value. The degree of uncertainty should influence the margin of error you have while making investment decisions.
In the words of the successful value investor Seth Klarman, investment risk should be viewed in terms of two dimensions:
- The magnitude of a loss
- The probability of a loss
In other words, it is the degree of certainty of different scenarios that may affect your invested capital.
For instance, a company may be entering liquidation and you believe that market participants are overreacting by overselling the stocks. Let’s say, in your analysis, after liquidating assets and paying off all liabilities, there is residual value left for ordinary shareholders. Hence, there may be three arbitrary scenarios if you buy in:
- Event A: A permanent loss of capital. -100% return, 1% probability.
- Event B: A partial realization of value. 15% return, 70% probability.
- Event C: A full realization of value. 30% return, 29% probability.
By listing down the certainty of different possible scenarios clearly, you will be more aware of the risks you are taking. The stock price of the above-mentioned company may be extremely volatile but as value investors who have done thorough research, we know that there is nothing to be afraid of. If there is only 1% probability of permanent loss of capital with great upside, we should be investing a bulk of our portfolio in this company.
Through this article, we hope that you have gained a better understanding of what risk means to value investors and why value investors view the market so differently from the rest.