A few years ago, my father walked into a popular high street bank with the intention of handing over a portion of his savings for them to invest on his behalf. As usual, the meeting he had with their adviser got down to the subject of risk. Was my dad a risk-seeker, or was he looking to take as little risk as possible on his investments? I suspect a fair proportion of people in these circumstances opt for somewhere in the middle (as did my dad). Looking at most (if not all) large high-street banks, they offer risk/return profiles bundled into neat little groups. Lloyds and Halifax for example have three risk ‘groups’ to pick from. Low, medium and high risk/return.
But is it really that simple? Surely everybody would like to maximise their return, therefore should they not all opt for the highest risk option?
High Risk = High Return?
Prevailing wisdom, as evident with these investment offerings, is that to achieve higher returns, you must take higher risk. It probably comes as no surprise that the ‘high’ risk group favours a higher allocation towards equities, the ‘low’ risk to bonds. For me, this raises a few questions, but the main argument is one put forth by legendary investor Howard Marks:
If riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.
This raises the first main point. Are we simplifying risk by substituting it for volatility? The notion of risk equating to volatility falls in line with the efficient market hypothesis and modern portfolio theory. Fundamentally, it assumes all investors are rational human beings who will walk into a high-street bank and demand high returns for taking high amounts of risk. Thus, the notion of beta as a measure of risk was born. A company who’s share price moves with a greater degree of volatility than the overall market would be considered to have a high beta, therefore by this definition volatility = high beta = high risk.
Issues with this Definition
There are issues with this definition and process. Firstly, it makes no effort to factor in the potential loss of purchasing power when choosing an investment. Were one to go to an extreme and consider investing purely in the safest possible asset, one may consider government debt. A common measure of a risk-free asset would be UK government bonds, or Gilts. However if we look at current ten-year Gilt prices they yield a little over 1.1%. With inflation at 2.7% this equates to a real-terms loss of purchasing power. Would this be considered risk-free?
This leads me to the definition put forward by Marks, that risk is the permanent loss of capital. As stated, an investment guaranteed to produce a negative real return would of course ensure loss of capital. Gilts may therefore be low in volatility, but the risk of losing money is that much greater.
With regard to equities, Marks states two possible reasons for permanent loss of capital: 1. Selling below your purchase price, either due to emotional panic, loss in faith of the underlying security, or economic necessity. 2. Fundamental reasons for the security being unable to recover from a fall in price. This leads me to a second quote from Marks:
The value investor thinks of high risk and low prospective returns as nothing but two sides of the same coin, both stemming primarily from high prices.
Marks is fond of stating that any investment can appear attractive if the price is low enough. By this definition, greater risk is taken when a higher price is paid for an investment. This is down to the fact that at a high purchase price expands the range of possible outcomes, and that negative potential outcomes are therefore that much more severe if they appear. Buying Netflix at 200 times earnings does not necessarily mean it will be a loss-making investment (has Netflix ever been cheap?), but it magnifies the possibility that any loss made will be that much more severe should it occur. On the other hand were it to drop 50% tomorrow, it would surely be less risky, not more. This again invalidates the notion that volatility is an accurate measure of risk.
As I have stated many a time, I look to find companies trading at cheap-to-reasonable valuations precisely because it helps limit the risk that any one investment will have a particularly negative outcome. Obviously it is almost impossible to eliminate the risk of a negative return, however a lower valuation can help to mitigate the downside.
What I find interesting is the difference between styles amongst investors. I would argue I am quite conservative, however plenty of people are happy to invest in unprofitable companies in the hope or expectation that profits will come and returns will be large. One is not better than the other, but what makes us different?
I am currently reading Peter Bernstein’s “Against the Gods“. In the book, he notes an observation by mathematician and scientist Daniel Bernoulli regarding how people intuitively calculate risk. He identifies that risk is calculated not only by the probability of an outcome, but by its expected utility (i.e. its desirability or usefulness). He gives the example of an aeroplane flight. We all intuitively know that the likelihood or probability of an accident during flight is very low, yet some people fear flying whilst others sleep through the heaviest of turbulence. Some people determine high negative utility when assessing the risk of a disaster, whilst others do not. The high emphasis placed on the small potential negative outcome skews their view.
When it comes to investing, it works the same way. An investor putting money into a junior mining company places high potential utility in the smaller probability of hitting a big deposit. The probability is low, but the potential for gain is large. Whereas another investor will only select defensive, conservative or lowly-valued companies as they place high negative utility in the potential for loss of capital.
So back to my father, and the options offered to him. In the long term, equities offer far greater returns than both Gilts and cash, but also greater volatility. And yet the ‘high risk’ portfolio has a greater weighting towards equities due to this volatility. But volatility means little without factoring time into the equation.
With this in mind, volatility starts to make a little more sense when assessing risk profiles. For someone looking to lock away their money for a year or two, equities do present greater risk because of the increased likelihood of greater volatility leaving them in an unfavourable position. However one, two or three year volatility becomes less important to someone with a five or ten year time horizon. Someone who can ride out the volatility that helps achieve long-term out performance. If risk amounts to the permanent loss of capital, starting valuations and time horizon matter.
I’d love to hear feedback, or any thoughts you have on this article. Contact me on Twitter @britishinvestor, or leave a comment below.