Managing risk is the tricky part of investing. The first thing taught about investing is that there is a trade-off between risk and reward. To get the big payoff, you need to take risk. The trick is managing the risk. And, having to think about managing risk is something just about everybody has to think about these days because we've been handed the responsibility of managing our own assets.
There are a lot of different ways to think about risk. Formal financial theory quantifies risk in terms of standard deviation, a mathematical expression that conveniently lends itself to producing all kinds of portfolio statistics that, in turn, depends on a particular probability distribution - the Gaussian Normal distribution.
There is a minor problem with this, in that investment returns aren't normally distributed. They have what is called a "fat tail." In everyday language, this means that we get extreme events more often than predicted by a normal distribution. Nassim Taleb has made a career as a hedge fund manager, positioning assets in conformance with extreme events, and as author of the best-seller "The Black Swan" describing extreme events.
As an aside for the non-academic reader, it should be mentioned that many academics have difficulty thinking in non-mathematical, non-model terms. If you can't express a concept mathematically, you'll lose many of them. Unfortunately, risk may be one of those concepts that doesn't lend itself 100% to a mathematical expression. Risk has many facets and means different things to people.
Some people look at risk from the perspective of the layman: risk is the possibility of losing money. This takes us down a different investment path and is mathematically awkward. In turn, the investment perspective changes. Instead of relative performance, proponents of this view tend to have absolute performance as a goal. They may give up return on the upside but, in turn, mitigate down-side performance. This approach understandably has gained adherents since the debacle of 2008 and early 2009.
Risk and the Efficient Market Hypothesis
How you view and manage risk depends on whether you believe markets are efficient. If you believe markets are efficient and that all publicly available information is reflected in stock prices before it can be exploited for abnormal gains, then there are straight-forward ways to diversify and eliminate all firm specific risk. The only risk that will remain is market risk which, by its very nature, many observers believe cannot be reduced. It is then up to the portfolio manager to choose the appropriate market risk to take, and this will depend on investor specifics such as age, tolerance for volatility, investment horizon, etc.
But what if you don't believe the market is efficient? Then how do you reduce risk? This isn't often discussed in a formal sense, but there are hints when investors describe their respective approaches.
These thoughts came to mind in reading "The Snowball Warren Buffett and the Business of Life" by Alice Schroeder. Reading between the lines, Buffett's approach to risk is interesting. My take is that he is extremely risk averse (at least in investing) and that he believes risk is reduced by obtaining information. It is well known that Buffett was severely criticized for not participating in the spectacular internet bubble of the late '90s. His reasoning was simple: he didn't understand the technology and, therefore, the companies. In fact, getting him to even own a computer was like pulling teeth; and he only used it to play bridge. To me, this is like being in the middle of a gold rush and refusing to participate because you know nothing about it. How many could resist? You'd have to be extremely risk averse.
In the book, we learn that it is only after medical complications and at an advanced age that Buffet has a colonoscopy, despite a known genetic predisposition to colon problems. This gave me pause. And yet, given the lifestyle he chooses compared to what he could choose, the money is not that important! To me these are puzzling contradictions.
But back to Buffet's risk reduction in investment markets. It appears that his main thrust is to reduce risk by obtaining information. He wants information on the business and on the character of those running the business. He does this in a way that few investors can - he gets people on the board and he replaces managers where necessary. He knows that few investors are in this position, and it is why he recommends that individual investors should invest in index funds. It is his way of warning about the hazards of investing, i.e. the risk of investing in the absence of information.
It is interesting that, to get to the point where he could get on boards etc., he took huge risks by investing a large percentage of his investable assets in a few companies--something he recommends strongly against. But, again, in these instances he had a lot of first-hand information.
This in no way is meant to play down the knowledge Buffett and his partner Munger extract from analyzing company financials. Few are as talented at gleaning information from a company's publicly available statements.
Thinking about information brought to mind the approach of Andrew Hallam who is building an enviable long-term record. Hallam reads the last 5 company annual reports before he invests, with a special focus on the footnotes and fine print where the real information on a company is found. This again is all about, from a formal stand point, risk reduction--information reduces risk.
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