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John Emerson
John Emerson
Articles (106) 

The ABCs of Risk

April 27, 2012 | About:

"I learned to embrace risk, as long as it was well thought out and, in a worst-case scenario, I'd still land on my feet." — Eli Broad

When one exposes the "bare roots" of successful value investing, it becomes apparent that the success of the practitioner is a direct result of his/her ability to successfully manage risk. In essence, the value investor operates as a low-level actuary whose goal is to minimize downside risk without negating the potential for upside gains. The task is not as daunting as it first appears if the investor is able to abandon his neurotic fear of short term failure.

Investment Risk Is Not Volatility

"Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in any given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management." — Benjamin Graham

In reality, risk is not consummate to the volatility of an investment; rather it is a direct function of an investor's ability to legitimately ascertain the underlying value of a security. Investment risk should be considered as permanent loss of capital rather that the fluctuations in the market price of an investment.

To paraphrase Buffett, the value investor should endeavor to price assets rather than prognosticate the movement of individual securities or markets in general. The problem is that the current perception which the investor holds frequently overrides any actuarial assessment.

An example is in order; ask any potential home buyer whether they would prefer to pay $100,000 or $120,000 for the same piece of real estate in the same location. Even the most mentally challenged buyer would agree that one would have to be a lunatic to pay the additional $20,000 assuming that one had a choice. However, if one was to study the movement of real estate prices and the perception which the movement creates, it is highly likely that a normally sensible individual would be more likely to buy at $120,000 than the lower figure.

The reason for the illogical response is a direct result of his perception of the movement of future home prices. If the market is dropping, most buyers want to wait to buy the house at a lower price. If the market is rising, the buyers want to lock in the purchase before the price rises further.

Ask any adept salesman about the necessity of creating a sense of urgency in closing a deal — no sense of urgency, no sale! Price becomes a secondary consideration if a potential buyer's perception of reality is heavily influenced by recent price movements. Likewise in the stock market, the perception of short-term momentum is one of the key elements in determining whether an investor decides to purchase or sell equities at any given point in time.

Irrational Fears Created by Market Drops and Perceived Hyper-Inflation

"We stand today at a crossroads: One path leads to despair and utter hopelessness. The other leads to total extinction. Let us hope we have the wisdom to make the right choice." — Woody Allen

The aforementioned quote by Woody Allen is applicable to modern day investor psyche, particularly if the market is declining on a daily basis. One only has to look back to late 2008 and early 2009 to witness a period extreme investor anxiety. During such times, the beleaguered investor is typically besieged with a steady stream of negative economic data which further enhances his sensation of impending doom.

Other individuals are convinced that hyper-inflation is certain to erode the value of every asset with the possible exception of a certain shiny metal. Such investors are particularly susceptible to Goldline commercials, spend a substantial portion of their income stockpiling canned goods and heirloom seeds which they secure in homemade bunkers, and frequently spend their afternoons listening to the Glenn Beck Show. Just poking a little fun Glenn — please do not take it personally.

For such investors the common perception becomes one of whether to opt for certain market declines or to sit in "low risk" assets such as cash and treasuries which will be eaten up by run-away inflation. The investor's perceived conundrum becomes one of whether to choose death by hanging or starvation (for the record I choose death by chocolate). Just as the old Tennessee Ernie Ford song suggests, "If the right one don't a-get you, then the left one will." It is not surprising that such investors frequently assume a fetal position or even worse, abandon all attempts at sensible risk management.

Of course such examples are of the extreme variety; although it should be noted that the average investor frequently experiences occasional periods of irrational investing patterns. Such patterns generally focus on speculation rather than sound investment principles which are largely a function their current perception of overall market or economic conditions.

In summary, the investor's ability to win the psychological battle is every bit as important as their ability to analyze securities since the conundrum is usually one of perception rather than reality.

Heads I Win; Tails I Don’t Lose Too Much

Mohnish Pabrai provides investors with the perfect model for addressing risk in layman's terms; heads I win, tails I don't lose much. His axiom suggests that an investor should endeavor to find stocks which offer limited downside while still possessing significant upside potential. Simply stated, an investor should always be willing to risk a little in hopes of recording a much greater potential upside gain.

The imagery involved in finding investors who are willing to accept a payback substantially under even-money in order to claim the right to call the tail side of a coin is not so far-fetched. Anyone who regularly buys lottery tickets, pulls on slot machines, or actively engages in any casino game of chance is a perfect example of an individual who routinely accepts under-laid odds. One has to believe that most of these gamblers are well aware of the fact that they are making actuarially unsound wagers. They simply do not care about probabilities in light of the prospect of a large pay-day or quick emotional gratification.

The goal of Pabrai's mantra is to limit downside risk without eliminating the potential for substantial upside gains when purchasing securities. The concept runs counter-intuitive to the thought process of most investors and financial advisers who assume taking additional risk is necessary to secure above-average market gains. The belief is a common fallacy which is perpetuated by "efficient market hypothesis."

Diversification and Risk

"Wide diversification is only required when investors do not know what they are doing." — Warren Buffett

A common investor fallacy suggests that excessive diversification significantly reduces investment risk. Peter Lynch coined the term "diworsifaction" to describe businesses which spread out their assets excessively thus diluting the core business which made the company profitable.

Individual investors can suffer a similar fate if they hold too many different equities in their portfolio. In reality, an extremely diversified portfolio frequently leads to mediocrity while not significantly reducing the non-market risk of an investment portfolio. Again I cite late 2008 and early 2009 when virtually every equity account was decimated without regard to diversification of equities.

James Montier cites a study that shows that 83% of non-market risk can be eliminated by holding eight stocks in his investing classic: "Value Investing: Tools and Techniques for Intelligent Investment."

Additionally, Montier cites a research study by Randy Cohen which reveals that the "best ideas" of U.S. managers from the period 1991 to 2005 outperformed the market by an average of about seven basis points (12% p.a. versus 19% p.a.).

The question one needs to ask is why would anyone with any investment acumen choose not to significantly overweight their top selections?

Margin Risk

"The most dramatic way we protect ourselves is we don’t use leverage. We believe almost anything can happen in financial markets… so even smart people can get clobbered with leverage. It’s the one thing that can prevent you from playing out your hand." — Warren Buffett

Without a doubt, the easiest way to go "belly up" in the market is to employ margin on a regular basis. Investment accounts get permanently damaged or destroyed by two basic methods; forced selling due to margin calls and unforced selling created by panic. In today's discussion we will focus on the former.

The lure of employing margin can sometimes become overwhelming, particularly when the momentum of the market is headed upward. When Mr. Market becomes overly optimistic he frequently becomes the "Pied Piper" of leverage players. Just like the proverbial children of Hamlin, the investment losses never return. Similar to death, margin calls are final and akin to taxes — the losses become virtually certain for the greedy investor.

Margin of Safety

"A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world." — Seth Klarman

All equities have an underlying value which may or may not be reflected in their current price. The problem lies not in the concept of underlying value; rather it lies in the ability of the investor to calculate it efficiently.

Since calculation errors are inevitable, it becomes incumbent upon the investor to purchase securities at prices so attractive that even large misjudgments do not result in devastating losses. Just like the commanders who implored their troops in the old Saturday-morning westerns: Don't fire until you see the whites of their eyes when it comes to purchasing stocks.

For my own purposes, I prefer stocks that trade at substantial discounts to their tangible book value as a margin of safety. So long as the company has a history of making profits over time and contains sufficient liquidity to survive an extended downturn in their business.

The Bottom Line: Sensible Risk and Suitable Temperament

"Success in investing doesn't correlate with I.Q. once you're above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." — Warren Buffett

Most successful investors possess three basic characteristics:

1) They possess patience.

2) They are not influenced by market fluctuations in their investment decisions.

3) They have the courage of conviction.

The key is to combine those three basic attributes with proper risk management. Investing is not a game that is consistently won by the smartest guys in the room; rather it is a game which is won by individuals with average IQs who do not destroy themselves.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 4.1/5 (28 votes)


Bob_in_Maryland - 5 years ago    Report SPAM
Hmmmm. If recollection serves correctly, "modern portfolio theory" (MPT) does advance the notion that diversification can lend itself to diminishing returns. So goes the theory. Just like the "efficient market theory".

But MPT is not to be digested, wholesale. For fear of indigestion. Or constipation.

Having said that, it is way too easy to make an "ill-timed" investment. In other words, an investor can purchase an exceptional security but fail in giving adequate/appropriate consideration to its' timeliness, or place in, a specific portfolio. Which might help to explain why one security can lag, sag, or - hopefully - provide that much deserved return. Talking opportunity cost, here.

General case in point. Yesterday, we were informed that the equity markets got a bump from some unexpectedly good earning releases ... particularly from the "news" that auto sales were strong in 1Q12. The markets provided a nice overall return. But that was yesterday. The question remains as to whether or not this news story (and the enthusiasm that accompanies it) will conform with those economic indicators both recently seen and available to us in the near future.

After all, it falls on us to synthesize what we learn - and think about those auto sales and consider how the data balances with our equally informed understanding - say - that the U. S. GDP rate of growth is ~2.00 +/-<1.00%. This may mean balancing seemingly contradictory viewpoints.

This type of task is not always easy for the individual investor. Economic Indicators (and, sometimes, political/social realities) have to be analyzed, and unfortunately, validated over the course of time. Thankfully, simple logic should dictate that a well-manged Corporation will recognize what is going on in the macroeconomic scheme of things and have its' balance sheet finely tuned up when the economic cycle signals timeliness for specific corporate/industry-based actions of growth.

The notion being made, here, is that when you dot those I's and cross those T's you'll have greater confidence about risk and will probably make better buy-hold-sell decisions. By the way, technical analysis is a complement to this decision-making process. Particularly at point of entry.
Benethridge - 5 years ago    Report SPAM
Great article. Thanks for writing it.

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