A key element of understanding the margin of safety, according to Howard Marks (Trades, Portfolio), is understanding, recognizing and controlling risk. This is another major topic covered by Chang Jing in last week's lecture for Peking University's Fall 2020 Value Investing Course.
What is risk?
According to Chang's definition, risk is the future potential adverse events that will cause permanent loss of capital when they take place, as well as the impact on our assessment of intrinsic value due to future uncertainty. This is a profound definition which consists of a few layers.
First of all, risk events are future probable events. Future events can have positive or negative impacts on our investments. We live in a probabilistic world. Uncertainty can be good or bad. It's the negative surprises in particular that we should be aware of.
Secondly, it has to result in permanent capital loss. An adverse event may be inconsequential. It may have already been priced in. It is the risks that are material and haven't been priced in that may cause permanent loss of capital.
Thirdly (and this is very important), risk includes all the uncertain factors that cause us to misjudge the intrinsic value of the business we analyze. In other words, our cognition inadequacy can cause us to behave in an unintelligent way.
A good way to view our cognitive inadequacy is to use a Venn Diagram in which there are three circles and a boundless space outside the three circles. The three circles are risk events, events that we know we know and events that we know we don't know. The boundless space consists of what we don't know that we don't know. It's what we don't know that we don't know that is most detrimental.
Sources of risk
According to Chang, there are three primary sources of risks.
- Internal business uncertainty - This type of risk event arises internally from the business itself. It will have an adverse impact on the business operation. For instance, IT system failures and management and employee turnover are both internal risks.
- External uncertainty - This type of risk is usually out of the business's control. It could be a macro risk. It could be adverse impacts caused by competitors' actions.
- Investors' own uncertainty factors - This type of risk arises from the decision maker, namely the investor. For instance, an investor may not know the edge of their own circle of competency. In this case, the investor may not recognize the risks involved in the business. An investor also has to make many assumptions when calculating the intrinsic value of the business. Each of the assumptions requires some judgments which are inherently uncertain.
How do we deal with risks?
Traditionally, there are two ways of dealing with risks within the investment community, namely diversification and hedging. Each approach has its issues. For instance, while reducing the negative consequences of a big positions, diversification also dampens the results from your best ideas. Similarly, while hedging can be helpful in case of adverse events, it can be very costly. But more importantly, while hedging may work greatly in the short term, in the long term it's a terrible idea. It also has a boundary of effectiveness.
Instead of using diversification and hedging, value investors should use margin of safety as the primary tool to deal with risks. We evaluate how much risk there is before making purchase decisions and we require a discount to intrinsic value to cushion against our misjudgment.
Risk matrix
Risk events can be placed on a two-dimensional matrix consisting of frequency and magnitude of adverse effects. Based on this matrix, we can define four types of risks:
Type A risk events: high frequency, high impact
Type B risk events: low frequency, high impact
Type C risk events: high frequency, low impact
Type D risk events: low frequency, low impact
Of the four types of risk events, type C events are the easiest to assess. Type B events are the most difficult to assess. Value investors should pay most attention to Type A events.
Conclusion
Risk is a key element in the margin of safety framework. Like margin of safety, in practice, there are many things to consider when we think about risks. Those who are better at recognizing risks, understanding risks and controlling risks make better investors. That's why it's best to evaluate an investor's return on a risk-adjusted basis because truly great investors should both generate returns and control risks. This seems especially relevant in today's market environment.
Read more here:
- Qualitative Factors Affecting Margin of Safety
- Basic Assumptions and Shortcomings of the DCF Model
- Notes From Peking University's Fall 2020 Value Investing Course - Yutong Bus Case Study
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