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Stepan Lavrouk
Stepan Lavrouk
Articles (260) 

Why Assessing Returns Without Risk Is Pointless

You cannot have one without the other

September 13, 2019 | About:

There is no such thing as a free lunch. Risk is a critical component to investing, and it will always be present in life, regardless of what you may be told by your local "risk manager." In efficient market theory, risk and return are always perfectly balanced - in order to achieve higher returns, investors have to bear higher risks.

I do agree with this to some extent, and I do think that markets are, generally speaking, quite efficient. The job of the value investor, however, is to sniff out those opportunities where returns are larger than the risk undertaken. Note, these are usually situations with very high perceived risk, which is what makes them unpopular in the first place. In fact, they can be so unpopular that a value investor’s own clients may rebel against them.

A perfect example of this situation is presented in the 2015 film "The Big Short" (based, of course, on real-life events), in which the investors at Michael Burry’s Scion Capital demand their capital back when they find out he is short credit default swaps of major investment banks. The perceived risk of that trade was very high to almost all outsiders; the actual risk was quite low.

On the flip side, consider an investor who earns good returns by taking outsized risk. He does this for years and years, and the whole time he is doing this, the market is going up. We have just witnessed the longest bull market in modern history (and, depending on whom you ask, we may still be in it). Is someone who levered themselves 10:1 and spent the last 10 years buying up every highly-priced tech growth stock in the S&P 500 a genius? That is only a partly rhetorical question. It’s hard not to question whether adherence to a strict value philosophy is really the way to go, particularly given that value has underperformed other factors like growth and momentum over the past decade.

Still, for every highly leveraged "genius," there are countless individuals who pursued the same strategy and fell by the wayside. As the trader-turned-philosopher Nicholas Nassim Taleb wrote in his 2001 book "Fooled By Randomness," survivorship bias is especially strong in finance. We see the lucky successful few, not the multitudes of unlucky fellows who perished.

For these reasons, I believe outperforming the market during good years is not a sign of clever investing, or of superior insight. Doing well, or at least better than the average, during bad years is. Bear markets, by their very nature, tend to be highly volatile and emotional periods of time. They often (but don’t always) coincide with political and social unrest in the world outside of the stock market. It’s very hard to concentrate on your portfolio when the world around you looks like it’s falling to pieces, let alone prosper.

This is what makes investors like Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) so successful - not winning in good years, but managing to not lose in bad years. In fact, I believe one of the reasons why Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) has underperformed the S&P 500 over the last 10 years is precisely because we have not had a significant adverse market event in so long. I have no doubt that if the market breaks in the near future, we will see Buffett and Munger assume the role of lender of last resort once again.

This is my point: do not rush to crown someone a stock market genius just because they have done well when times are tough. You do not know what their risk has truly been until the music stops.

Disclosure: The author owns no stocks mentioned.

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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