Watch Out;The Surface Is Slippery

Someone is driving from Mumbai to Goa to usher in the new year. What is the risk of meeting with a road accident? What is the chance that it will rain on a September afternoon in Mumbai? Should one venture out with or without an umbrella? What is the risk that BSE Sensex will plummet by 50% in next five years?

In daily life we all come across various kinds of risks and often effortlessly take measures to control them without even feeling the need of a formal process. At the same time it can’t be gainsaid that people whose risk management systems are more systematic and evolved tend to take better decisions. Indeed it is difficult to overstate the role of understanding, assessing and controlling risks for a happy life.

As human beings we abhor risk to the extent that we don’t mind scaling down our ambitions if bigger goals imply more uncertainty. However it doesn’t prevent people from living with, or even accepting some risk if the pay-off is favorable. Alan Greenspan, ex-Chairman of US Federal Reserve Board, had commented in 1994 that ” The willingness to take risk is essential to the growth of a free market economy. If all savers and their financial intermediaries invested only in risk free assets the potential for business growth would never be realized”.

It is also quite pertinent to note here that we human beings typically have an exaggerated belief in our ability to spot and address risks perhaps due to facing, understanding and managing risks over thousands of years – and due to the fact that we, unlike any other life form, can figure out that something is dangerous even without experiencing it.

Risk: Uncertainty and consequences

So, how can risk be defined? The most obvious point that risk alludes to is uncertainty. Generally, there are many events, not all of them palatable, that can play out in future. This is best expressed in words of Elroy Dimson “Risk is more things that can happen beyond what we have planned”.

In addition, impact or consequence of these events too contributes to the risk. For an event to be bad we need to know how bad it is. An innocuous event, even if it has a very high probability does not add to risk. Thus risk, if not quantified, is better termed as uncertainty. In a way risk can be construed as a product of probability of failure, and consequence of failure.

Keeping in mind that Investment essentially is all about dealing with future it is difficult to miss out the relationship between investments and risks. It is impossible to know with certainty about future and hence risk is inescapable in the process of investment. Managing risk is very important to reduce the element of luck in investment performance.

More risks = higher expected returns

A rational economic agent seeks higher return from an investment if she is taking higher risks in those investments. A large part of modern finance theory is based on this basic concept which can be seen in the below exhibit in the shape of the so called capital market line which suggests that returns increase proportionately with risk taken.

img_4527

Taking a step further, investment performance of a portfolio of assets should be seen not just on the basis of returns and instead, should also be looked at in context of risks taken. For example a return of 35% from investment in a small market capitalization, commodity stock may not necessarily appeal to every investor versus a return of 20% from investment in a large market capitalization, consumer staples stock. A small cap stock in the commodity sector has typically a higher possibility (versus a small cap stock in consumer staples sector) of decline in price. Of course the possibility of higher returns too is higher. Thus returns must be adjusted for risks taken in the portfolio for an apple to apple comparison.

More risks do not necessarily mean higher actual returns

As the concept that returns have to go up proportionately with risks makes sense, at least directionally, shouldn’t – as a corollary- people who take higher amount of risks make more money? No. If this were to be true everyone would load on riskier instruments and record solid returns which in turn would suggest that those instruments were not risky in the beginning.

The exhibit below, from Howard Mark’s book titled ” The Most Important Thing” gives the relationship between risk and returns a better perspective.

img_4529
As seen in the above exhibit, as higher risk is taken the outcome becomes less certain as evidenced in widening probability distributions.The reality is that investors who take more risks may or may not get better returns even as they expect better returns. Expected returns increase with higher risks but the latter also increases uncertainty.Riskier investments have higher probabilities of making higher profits but they also have higher probabilities of lower profits and may even have some probability of making some losses as seen in the fourth normal curve in the above exhibit.

Imprecise for future, vague for past

One cannot be definitive about risks. Risk is difficult to quantify ex-ante but interestingly it is equally difficult to measure with precision even ex-post facto. Even after a stock has moved in one direction we do not get any new information – versus what we had prior to its movement – regarding the risk involved. Let’s say we bought a small cap commodity stock which jumped by 35% in 12 months. Does this – or for that matter, a scenario where the stock declines by 20% – add anything new to our assessment of risk involved in the stock? Not really. It’s only after we have observed statistically significant number of relevant data that we can draw some conclusions.

The situation is quite similar to a forecaster who predicts that there is a 65% probability that the stock will go up by more than 20% in 12 months. Let’s say the stock actually rises by 23% in 12 months. Now, was the forecast right? Since he had a forecasted probability of between 0 and 100 it can’t be said with precision if he was right or wrong (even though directionally he can be said to be right since he had predicted more than 50% for the event which eventually took place).Had he given a probability of 0 or 100 the verdict could have been precise.

In real life there are very few situations with probability of 0 or 100 and obviously they are quite simple to deal with. Such situations do not pose any risk.

Beauty lies in the eyes of the beholder

Not surprisingly, in keeping with his credo of keeping things simple Warren Buffet says ” My definition of risk is the possibility of permanent erosion of capital”. This brings us to another very important feature of risk – it is not absolute and instead depends on the protagonist.

Risk is a matter of opinion, is difficult to pin down in an equation and differs even in perceptions of different people. One investor may see capital loss as risk while some other investor may see poor returns as risk. Someone may see poor portfolio performance over one year as risk and some other person can say that for her risk means bad returns over five years.

Advertisements