April 1, 2008

Risk vs. Uncertainty

I tend to evaluate and buy risk but I ignore uncertainties when thinking about equity valuation. The difference between the two is subtle yet very important. The market tend to hate and avoid both, which can create opportunities. The current market situation contains a lot of uncertainty and risks as well. I am willing to take on risk in face of uncertainty while many investors are willing to take neither and that's why you see treasuries are yielding negative real returns.

Uncertainty, in my mind, is when you can't articulate a set of finite scenarios and attach a probability to those scenarios. Risk, on the other hand, is where an intelligent investor can outline a set of outcomes with expected probability of occurrence. With this definition in mind, the uncertainties facing the investment environment in the short run today are :

  • Political uncertainty : who wins the US election, what kind of tax regime will be instated, fiscal budget management ...etc. All these issues are uncertainties as you can't pin point accurate outcomes with realistic attached probabilities.
  • Economic uncertainty: the rise and fall of economic activity and which sector is under pressure, job loss ...etc are another set of uncertainties that companies or investors have no control over nor can they do anything about.
  • Financial bankruptcy uncertainty: you do not know who will it be and what will be the impact. It could be a benign event if some small regional bank went under or even a big investment bank. The impact is not quantifiable so it is uncertainty for me.
  • Regulatory uncertainty: with the introduction of new banking regulation, its impact on financial is uncertain as the details of these regulation are unclear.

So what kind of risks in the short term are facing the markets:

  • Credit risk: There are a lot of credit risks and issues that face certain sectors more than others. The Banking sector faces more credit risk than any other sector due to its nature. There are risk in commercial real estate defaults, although as I wrote before I think it will be benign. There are increasing consumer loan defaults and mortgage ARM resets that can lead to more write downs. You can attach an estimate of $100- 200 Billion in write downs for this risk.
  • Inflation risk: This has become more acute in recent periods. An increase in inflation will reduce your real return so once factored in your analysis it will affect return expectation.
  • Earning risk: the risk of decline of corporate earnings has increased with slowing economy. This risk will lead to lower valuation of equities.
However in face of these risks there is an upside :
  • credit improvement: there are signs of thaw in the credit market. You can see a lot of risk spreads coming down as well as a lot of the credit default swaps on banks have declined significantly. If credit environment improve you can see a lot of upside in bank earnings as a lot of the write downs will become write up.
  • Cash has been accumulating in money markets and low yielding treasuries; the question is how long will investor be satisfied with meager returns before they accept risk? These funds can give a boost to equities and other depressed asset classes like real estate.
Given these risks I think there is room for an opportunity in the most beat up and distressed areas of the market that being banks, retailers, real estate and credit instruments. If you have been following my posts and investment you can see that I have bought the risk into these areas in face of the uncertainties that the market is worried about. Risk vs uncertainty is an important distinction. Knowing which is which can allow the investor to earn good return.

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