It is well-known that for value investors, risk is not standard deviation stemming from prices. Rather, it is the product of the expected loss times the probability of that loss occuring. One of the best efforts in defining risk that I have encountered comes from Seth Klarman (Trades, Portfolio), who, in one of his investor letters, provided a detailed explanation on how he thinks and acts upon this definition of risk.Ă‚
“The risk of an investment is described by both the probability and the potential amount of loss. The risk of an investment—the probability of an adverse outcome—is partly inherent in its very nature. A dollar spent on biotechnology research is a riskier investment than a dollar used to purchase utility equipment. The former has both a greater probability of loss and a greater percentage of the investment at stake.
In the financial markets, however, the connection between a marketable security and the underlying business is not as clear-cut. For investors in a marketable security the gain or loss associated with the various outcomes is not totally inherent in the underlying business; it also depends on the price paid, which is established by the marketplace. The view that risk is dependent on both the nature of investments and on their market price is very different from that described by beta.
Here is a critical aspect of Klarman's philosophy: Risk goes hand-in-hand with the price we pay for our securities and the inherent nature of the business. Sometimes we can compensate one component with the other, but it is certain that when we try to minimize both components the amount of risk that we are incurring into is low.
While security analysts attempt to determine with precision the risk and return of investments, events alone accomplish that. For most investments the amount of profit earned can be known only after maturity or sale. Only for the safest of investments is return knowable at the time of purchase: a one-year 6 percent T-bill returns 6 percent at the end of one year. For riskier investments the outcome must be known before the return can be calculated. If you buy one hundred shares of Chrysler Corporation, for example, your return depends almost entirely on the price at which it is trading when you sell. Only then can the return be calculated.
Unlike return, however, risk is no more quantifiable at the end of an investment that it was at its beginning. Risk simply cannot be described by a single number. Intuitively we understand that risk varies from investment to investment: a government bond is not as risky as the stock of a high-technology company. But investments do not provide information about their risks the way food packages provide nutritional data.
Rather, risk is a perception in each investor’s mind that results from analysis of the probability and amount of potential loss from an investment. If an exploratory oil well proves to be a dry hole, it is called risky. If a bond defaults or a stock plunges in price, they are called risky. But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren’t risky when the investment after it is concluded than was known when it was made.
There are only a few things investors can do to counteract risk: diversify adequately, hedge when appropriate, and invest with a margin of safety. It is a precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount. The bargain element helps to provide a cushion for when things go wrong.”
Value investors demand a wide margin of safety to allow for the other component of risk, the uncertainty of the business and its nature, to behave differently from our expectations. In that case, we are hedging via the price we pay any possible outcome that may dampen the future outlook and therefore the price. In one of his interviews, Klarman mentions that during the 2008 crisis, his team was stressing outcomes for the next three years as if the crisis were to get worse, not better. Only after a security looked attractive in spite of these adverse scenarios did Baupost decide to invest.
I believe that implementing this philosophy requires two things: discipline and patience. The discipline is required to have the appropriate mental models and cash available to understand and seize opportunities. Patience is required to wait until prices are at a point where they offer a wide margin of safety. Only when these circumstances mix, the real risk of an investment is minimized and our return potential is maximized. This approach steps away significantly from the efficient market hypothesis, provided that risk is not standard deviation. However, it certainly provides an approach that comes nearer to real life situations.
What do you think?
