Risk is one of the hardest things to define in investing... Or is it?
Many very clever people spend a lot of time analyzing risk and what it means for particular investments. A lot of financial commentators also spend a lot of time writing about risk and how we can reduce risk in our portfolios.
Most of the time, these people are referring to volatility when they talk about risk. Asset volatility tends to be driven by uncertainty, which is pretty much uncontrollable. There is no point in trying to control uncertainty, as there will always be a level of uncertainty in the global economy and specific companies. After all, no one can predict the future.
But there is something we can all control when we are investing, and it is far easier and more simple to rectify than uncertainty and volatility. In fact, it is one of the easiest ways to reduce risk.
How to reduce risk
The easiest way to reduce risk is with research. Most risk comes from not knowing what you are doing. The easiest way to get around this issue is with research and analysis.
You might argue that if it was that simple, every investor would have a zero-risk portfolio. Unfortunately, it is not simple at all. Just knowing that the easiest way to reduce risk is with research is not enough. One actually has to do the research as well. That is the hard part.
Research takes a huge amount of time and effort, and some of the time, the information is just not available. It requires in-depth knowledge of the company one is looking at and its competitors, as well as the sector as a whole and the challenges, opportunities, strengths and weaknesses of individual businesses.
In my experience, the best investors are the ones who are willing to take significant, high conviction positions in just a few securities, which they spend weeks and months analyzing before pulling the trigger. They only buy when they are certain they know enough about the business to be able to build a high conviction position.
Retail investors are at a disadvantage because they do not have the time or the connections to do the research required to gain an edge most of the time. Business owners may have an advantage because they are already plugged into the dynamics of different industries. This is why it is important to invest within your circle of competence and avoid uncertainty.
The unknown unknowns
However, there is another factor we need to consider. No matter how much research one does around a security, there will always be unknown unknowns - things we do not know and have no way of knowing.
In some respects, getting around this issue is both easy and hard. The easiest way to mitigate the risk of unknown unknowns is to acknowledge what we do not know. Once we have acknowledged we do not know everything, we can adjust our figures.
This is where the margin of safety comes into play. Suppose we do not understand how an uncertain macroeconomic backdrop will impact the company (after first exhausting all of our research resources). In that case, we can incorporate a margin of safety into the valuation process in order to build a cushion into the numbers.
In this situation, ideally, one would find a company with a certain level of protection against macro volatility, but that might not always be possible.
Put simply, the best way to reduce risk is through research and acknowledging that we won’t know everything all of the time. If we do this, we can incorporate a margin of safety into the numbers to ensure that it won’t be terminal to the investment case if we don't know something.
