Let's Talk About Risk (And Return)
The actual risk of a particular investment cannot be determined from historical data. It depends on the price paid. -Seth Klarman
Most financial theory and academic financial models are based on the notion that the volatility of an asset defines how risky it is. But is volatility really the best definition for risk? The following outlines why I think financial theory and academia are flat wrong about how they define risk.
Definition of Risk?
Most financial professionals will tell you that taking more risk will get you higher returns over the long term. What they are referring to when they say “risk” is volatility. Volatility is simply a measure of an asset’s dispersion of returns over a specified time period, and it’s usually measured as either standard deviation or beta. But the only thing that volatility can tell us is how much an asset’s price has fluctuated in the past. That’s it.
While the finance profession has its reasons for defining risk as volatility, I take a completely different view. Volatility is not risk; rather, risk is the possibility of permanent loss of capital. And it’s through this lens that I evaluate investment risk.
Just Say No
Just last week, as I was having lunch with my dad, we ran into my former little league baseball coach, Dave. Dave has been successful over the last ten years accumulating investment properties. Perhaps without knowing it, Dave offered an absolute gem of investing advice. When asked how he knows what to pay for an investment property, Dave said, “I offer at a price where I know I can make money. If the seller can’t do it, I walk away.”
What Dave is saying here is that an investment is more risky when he overpays for the underlying asset. Therefore, when the deal doesn't make sense, Dave just says no (D.A.R.E., anyone?). As investors, when we can't buy an asset at a reasonable price (as much as we might love the asset itself), let's resolve to just say no and walk away.
And while it's more risky when we overpay for an asset, the reverse is also true; we can lower risk by investing only when we can buy the asset for less than it's fair value.
To further cement this point, consider what Howard Marks, founder of Oaktree Capital and one of the great investment minds of our time, says:
“...the riskiest thing is overpaying for an asset, and the best way to reduce risk is by paying a price that’s irrationally low. A low price provides a ‘margin of safety,’ and that’s what risk-controlled investing is all about...All you have to do is refuse to buy if the price is too high given the fundamentals.”
Sound familiar? Maybe Dave is onto something...
Have Your Cake
So the notion that there is a direct relationship between risk and reward (more risk equals more reward) is only true if you view risk as volatility. But remember, we said that risk is not defined by volatility, but by the permanent loss of capital. So in that context, risk and reward have an inverse relationship (move in opposite directions) rather than a direct relationship. So it's possible to invest in a way that both reduces risk and increases returns. This is called having your cake and eating it too!
Allow me to illustrate using Dave as an example. Let’s say Dave is buying a real estate rental property worth $100,000. And let’s assume he can buy the property for $90,000 instead of paying the full $100,000. Paying $90,000 for a property worth $100,000 will earn higher returns AND be less risky than if he paid the full $100,000!
Now let’s pretend that Dave can buy the $100,000 property for $50,000. Is this more risky? No way! But baffling as it is, finance theory and academia says that because the price dropped to $50,000, it’s a more risky investment. As you can see, volatility can actually create opportunity for astute, long-term investors.
Application for Stock Investors
While we’ve been using real estate as an example, we can apply the same concept to stocks too. Because, at the most basic level, stock investing is simply buying an ownership stake in an asset that generates cash flows; same as real estate.
Instead of continuing to charm you with my excellent wit and writing ability (ha!), I’ll let one of the most successful and admired investors of all time share his perspective. Here’s Warren Buffett on risk as it pertains to stock investing:
“I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, “I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.” I would decline — perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice — now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more...
...Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta (read: volatility) would have been greater. And to people that think beta (volatility) measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million…”
Essentially, my little league baseball coach (Dave) and Warren Buffett share a similar philosophy on risk: the best way to reduce risk and increase returns is to buy assets at a discount to their fair value.
We Don't Know What We Don't Know
That’s not to say that just because you buy at a discounted price that you’ve eliminated all risk. There are always unforeseen circumstances that could introduce risk. And in general, people tend to do a lousy job of estimating future risk events. Howard Marks illustrates this point well:
“I tell my father’s story about the gambler who lost regularly. One day he heard about a race with only one horse in it, so he bet the rent money. Half way around the track, the horse jumped over the fence and ran away. Invariably, things can get worse than people expect.”
While there’s no such thing as a risk-free investment, it’s ALWAYS less risky to buy an asset at a discount rather than paying full price. While this may seem elementary, you might be surprised how rarely this concept is applied on Wall Street.
What’s your definition of risk? Does this change the way you think about risk in your investment portfolio? How do you attempt to decrease risk when investing?
Ben Malick, CFA, CKA