June 26, 2008

What is Risk?

A discussion about risk and return came up in the comments section of a blog, which gave me the idea to put my thoughts on the subject in this post.

Majority of investors talk about risk and return in the same breath, the saying goes " no risk no return". I find that one of the most erroneous terms coined by Wall Street, and there are many of them. Actually the way I see is by limiting my risks, I will earn above normal returns.

Investors should distinguish between risk and volatility. Volatility is backward looking and pertain to price movements day-to-day, it is actually defined as the standard deviation of prices around their historical mean. There is not much insight from that figure, if any, to your investment decision making process.

However, Risk in investing should be future looking in nature and not backward looking as volatility. Price movements and historical financials bear little on an investment's risk profile. One thing is clear in my mind Risk does not equal volatility and more certainly risk does not equal more returns. Wikipedia defines risk as:
.... a concept that denotes a potential negative impact to some characteristic of value that may arise from a future event, or we can say that "Risks are events or conditions that may occur, and whose occurrence, if it does take place, has a harmful or negative effect". Exposure to the consequences of uncertainty constitutes a risk. In everyday usage, risk is often used synonymously with the probability of a known loss.
And it is calculated as:
Risk comes from the assessment of the company operations and economics accompanied with probable future adverse scenarios that the business might endure. Your analysis of these scenarios and their affect on the financial health of the business is how you assess how risky a business is. I try to find businesses that have limited probable risks associated with their operations. In this case more risk does not mean more return, it actually means exposure to more possible losses, which I am certain most investors want to avoid.

The example best used with the saying "more risk more return" applies to choosing between various types of asst classes, for example money market vs bonds vs stocks. Wall Street argues that with stock you will make more returns due to more risk involved with owning equities. To illustrate my point how erroneous that saying is, I ask you which asset will you hold: a GM bond or P&G common stock?


O&G Engineer said...

Aha! Great post Sami. High risk = high return IS the biggest fallacy on Wall Street. Deep value investing has always taken advantage of the 'low risk high uncertainty' scenario and will continue to as long as people stay irrational. Have you read The Dhando Investor? I'd assume you probably have ;)

- Ali

Sami said...

Thanks Ali.

Yup risk and uncertainty are way different and one can take advantage of that.

Yes I have read it. it is a good book and I like the simple manner that Pabrai explains the risk and uncertainty, I liked very much the hotel story :)