Calculating risk is an integral part of the investment process. Some investors and analysts like to use financial metrics such as beta and standard deviation to calculate the risk of a particular investment. However, for most investors, the process is much more complicated. Unless you want to rely on mathematical figures, which only provide a gauge of risk based on past data, there's no set formula for evaluating company-specific future risk.
This presents a problem for most investors. Almost every professional investor has a different standard they used for measuring the risk of a particular investment. Measuring risk not only depends on your understanding of accounting but also your knowledge of a specific sector or industry.
For example, it is not easy to find undervalued insurance companies if you do not understand how the sector works. The same can be said for many manufacturing businesses and technology companies.
Buffett on risk
Warren Buffett (Trades, Portfolio) spoke on this topic at the 2019 Berkshire Hathaway BRK.A BRK.B annual meeting of shareholders. Responding to an investor who asked him to give some insight into his process for evaluating risk in a particular investment, the Oracle of Omaha replied:
"But we don't have any formula that evaluates risk, but we certainly make our own calculation of risk versus reward in every transaction we do. And that's true whether it's marketable securities, that's true whether it's private investments, that's true whether it's making an investment in a business.
And sometimes we're wrong, and we're going to be wrong sometimes in the future. You can't make a lot of decisions in this business without being wrong. But we don't think the procedure — or the results — would be changed favorably by having lots of committees and lots of spreadsheets and that sort of thing."
My main takeaway from this is that while evaluating risk isn't a simple process, it should still be kept simple. Trying to complicate the process with spreadsheets and formulas will only confuse the situation and possibly lead investors to overlook a key component.
"The main thing is you have — are you reasonably sure that you know what you're doing? And if it gets past that hurdle, then we go on to figure out the math of gain versus loss and how much loss we can afford to take in anything. And we're willing to take what sounds like large losses if we think that the rewards are more likely and proportional."
Like so many parts of investing, risk is one of those tricky things that has no correct answer. However, by sticking with investments that fall inside your circle of confidence, you have a much higher chance of understanding the business and the risks that it is exposed to. If you don't understand the company, trying to understand the risks the business faces can be complicated and challenging.
Even if you understand the business entirely, there's never any guarantee of avoiding losses. Investors will always have to face the risk of unexpected events. However, by understanding the risks a specifit type of company faces, we can better prepare ourselves to face these unexpected risks when they emerge.
Take oil companies, for example. If you understand the production costs and well economics of the business, you're better positioned to understand how falling oil prices (the most significant risk these companies face as of the writing of this article) might impact the enterprise.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Warren Buffett: Kraft Heinz Is a Good Business, but the Price Was Wrong
- Warren Buffett on Why Amazon Could Be a Value Stock
- Will Berkshire Hathaway Buy Back More Stock in 2020?
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