By Dan Erdle

Overview

The modern way to approach risk, and the one used by the financial industry, is to define risk as volatility. If something moves up or down a lot, that means it is risky. The financial world has even come up with a mathematical way to measure risk called beta. If you take a finance class or hang around hedge fund professionals, you will learn all about mathematical formulas involving beta and how beta (volatility) determines how risky a financial asset is.

My contention is that the investment industry is wrong. Financial risk is not volatility and by using things such as beta (volatility) as a measure of risk we mis-frame problems, overlook actual risks, and miss opportunities because we label them as risky. What volatility can create is emotional discomfort, but this emotional discomfort can be a source of opportunity because it causes other investors to make irrational decisions such as selling you a great business at a discounted price. In short, in dealing with risk we should not consider how the current market price relates to other recent market prices, instead we should focus on how the current market price relates to the underlying worth of the investment.

Rather than defining risk as simply volatility, it would be better if we thought of risk as the probability that you will suffer a permanent loss of money. This better definition of risk acknowledges that the future is inherently uncertain, that investing is a probabilistic activity, and that what we should care about is the chance that our investment fails overall in the long term.  Volatility is necessarily temporary. What we should think of as risk involves how the merits of an investment decision will effect us permanently.

In practice, defining risk as the probability that you will suffer a permanent loss of money will force us to think less about the fluctuations of market prices and instead on 1) the merits of the underlying investment and 2) the quality of our own decision making.

Standard Industry View

I believe that the investment management industry has settled on defining risk as volatility not because it is the truth but because it is convenient. What volatility has going for it is that it can be mathematically measured (beta), it can be analyzed statistically, it can be thrown into formulas while spitting out clean answers, and it avoids messy subjective interpretations. These are all things the mathematically inclined people in academia and high finance are likely to find appealing.

The accepted approach to risk relies on two basic premises. Both of these have been so widely spread by professionals that they have become part of the way most average investors think as well. I believe both premises are basically wrong, but are still widely believed:

1. Risk is defined as volatility (beta). More Volatility means more Risk.
2. There is a positive linear relationship between risk and reward. Meaning if you want more return you have to take on more risk (More Risk, More Return). Inversely lower risk investments are lower returning.

The standard view of risk is summarized by the graph below.

High risk brings high return. But if you have a lower risk tolerance that is no problem because all you have to do is put your money in lower volatility things like cash, CD’s, or government bonds. According to standard practice, by investing in lower volatility assets it means you have lowered your risk.

This should all sound familiar because this is industry orthodoxy.  Part of its popularity is also that it all kind of sounds good. I will admit it does have a nice intuitive feel to it. I can see why this view has caught on.

But even though it has a good internal logic I believe it is essentially wrong.

Lets look at a few of the implications of the standard industry view of risk.  In the numbered headings below I lay out a several observations that refute the standard view of risk.

1. Low Volatility Does Not Make Something Less Risky

If we were evaluating the future prospects of an asset and I told you that there was an almost 100% certainty that the asset would be worth less in real terms in 10 years, you would probably say that it is a risky investment. An investment that is sure to be worth less in real terms in the future certainly isn’t a safe investment. But this is exactly what traditional finance theory says about the asset I am talking about.

What asset am I talking about?

Its Cash—whether in paper form or in something like a checking account, savings account, or short term government notes. It is almost certain that a decade from now cash that has just been sitting in idle form will be worth far less than it is today.

But cash is not volatile, so it doesn’t count as risky under modern finance. If you look at your money in your checking account day-to-day it won’t fluctuate at all in nominal terms, but over the long term cash is one of the most risky assets you can keep your wealth in because it is almost certain to decline in value. In fact over the past 100 years, inflation has brought the purchasing power of a dollar to only a nickel.

Defining risk as volatility would completely mislead you in making decisions in this situation. Modern finance treats cash as an essentially risk free asset because it doesn’t fluctuate. It is irrelevant that an investment will almost certainly lose all of its value in the future; all that modern theory cares about is that it does so slowly.

This isn’t just true with cash, it scales all the way up to other assets as well. For example, bonds are almost always seen by investment professionals as less risky than stocks. The reason for this opinion is that bonds are seen as less volatile than stocks. But in my opinion bonds could easily be much more risky than stocks even though they are less volatile. For example if the yield on a bond doesn’t compensate you above inflation, or if the yield underestimates the probability of default, or the bond exposes you to capital loss in a rising interest rate environment, I would say that the bond is more risky than a stock even though the bond is less volatile.

This is true of all assets. Contrary to popular belief, just because one asset is less volatile than another does not mean that it is less risky. In fact some of the least volatile assets can be the most risky over time because they guarantee that you will lose purchasing power.

2. Volatility Does Not Necessarily Make Something More Risky

The standard belief is that if an asset moves a lot in the short term than it must be risky. But even on its face this isn’t really exactly true because almost no one would complain if their investment was volatile to the upside.  Almost no one has ever said that something they own has been so risky lately because it has been going up to fast.  So it seems like if we care at volatility at all, we should only care about volatility to the downside.

But I would argue that even if something is volatile to the downside that doesn’t make the investment more risky if the decline is only temporary. Unless something has changed with the merits of the underlying investment, I don’t think we should consider it more risky. As I stated before I think a better way to view risk is the probability that we permanently lose money.  Permanent losses would come about if something negative happened to our underlying investment thesis; this is different from price fluctuations in the market.

Take a look at the stock charts below.  These 3 charts follow Apple Inc.  The first two charts shows that in little over 5 years Apple has had 2 major declines of over 30% each.  The first happened at the end of 2012 and into 2013 and the second decline began in the middle of 2015. If you were only shown the two charts below you would say that Apple was a very risky investment.

Yet only looking at the price volatility during these two time frames would mislead you as to the actual risk regarding the merits of investing in Apple. If we zoomed out further we would see that even though Apple has undergone these two major declines, these declines actually tell us very little about our likelihood of success over our entire holding period.  Below is a chart of Apple beginning just before the first decline shown in the top chart up until the February 2018.

Notice how the two large declines that were so prominent in the first two charts fade to irrelevance as we expand the time frame. During the overall time frame of the investment, which included the two major declines, Apple grew to become the largest company in the world by market value. If we had relied on short term volatility to tell us how risky the investment, we would not have properly considered the underlying investment merits of investing in this great company.

Warren Buffet recently discussed a similar situation with his own company Berkshire Hathaway.  During his time as CEO, the market price of Berkshire has declined a whopping 50% three times and almost 40% another time.

Yet during this time Berkshire Hathaway has been one of the most “sure thing” investments a person could have made.  The volatility in the market price would not have told us anything about the chance of permanently losing money by making an investment in Berkshire.  The probability of permanently losing money from an investment in Berkshire over the long term was extremely low; yet if we had defined risk as volatility we would have concluded that Berkshire was a risky investment.

3. You Can’t Get Higher Returns Just By Taking on More Risk

It follows from traditional thinking that the in order to get greater returns you must take on greater risk. Riskier investments provide higher returns. But a simple logical examination reveals that riskier investments logically cannot always be counted on for higher returns. If riskier investments always produced reliably higher returns, they wouldn’t be riskier.

The idea from standard practice that you can sort of just “pick out” what returns you want to receive by selecting your level of beta (risk) seems silly to me.

It appears much more reasonable to me say that for each investment opportunity there is some probability of success, and that the probability of success has much more to do with the underlying merits of the investment than the recent price action (volatility) in the public markets.  In other words risk is not something that comes from the public markets, but is inherent in the investment opportunity itself. Figuring out the chance that an investment will do well over our investment horizon should be how we analyze risk.  We cannot outsource our thinking to recent price changes in the market.

We operate in an uncertain future and as a result even the best investors won’t be successful 100% of the time.  There will always be failures no matter how well we analyze investment opportunities. But  our job as investors should be an attempt to tilt the odds as much in our favor as we can. Focus on long term probabilities: does some factor related to this investment increase or decrease the chance that it will be successful.  Focus  your time considering the factors that will increase the probability of success of our investments over the long run. We want as many things as possible on our side. This also means avoiding things that would decrease our probability of success, including the consideration of irrelevant factors such as what the recent price quotes have done in the market.

In the next section I will discuss one of the primary things that I believe increases the probability of investment success and thereby decreases investment risk.  It is a focus on valuation.  We should think about the value of the underlying investment and whether we can acquire the investment for less than we think it is worth.

Valuation As a Tool to Reduce Risk

Risk seems to me to be dependent more on valuation than any other factor. Valuation is the lever by which risk gets either ramped up or reduced. For any level of cash flow, the more we pay for it, the greater the risk and lower the return. Conversely, as we reduce valuations we reduce risk. As we continue to pay less and less we are letting the pressure out of the balloon that could burst.

Lets say an investment pays off $20 annually. Paying $100 for this opportunity is less risky than paying $200.  And the risk would only keep increasing as we paid greater and greater sums for that $20 of cash flow.  If we paid something like $1,000 for $20 of cash flow this would be quite risky.  Notice also that it would be very low return.  This is in direct contrast to what the standard industry definition of risk would say.  Standard thought is that since this is a high risk situation the returns should also be high.

Here lies a major discovery that is at the heart of what I am trying to get across. The truth about the relationship between risk and return is the exact opposite as what we are taught in finance and what is believed in the investment industry.  High risk does not bring greater returns, but rather brings lower returns. As you pay more and more for any amount of future cash flow you are not only increasing risk but also decreasing returns.  This is the exact opposite from what we are told.

Therefore good investors think of high risk/low return as two sides of the same coin. They go hand in hand. As does the possibility of low risk/high return. As we pay less for any amount of future cash flow, we decrease the amount of risk and also increase future returns.

Another image I like to use is thinking of valuation like a ladder.  The valuation we pay places us on the ladder. The higher the valuation (the more we pay for each dollar of cash flow) the higher we start on the ladder. You can see that by starting higher up on the ladder not only do you have less room to the upside but also further to fall if something goes wrong. If we start on a lower rung (a lower valuation) we have greater opportunity in the future and also a shorter distance to fall if something goes wrong in the future.

This valuation ladder is a good visual to drive home the main point of risk vs. reward.  In direct contrast to what we are taught, high risk should not be associated with high return. In fact the opposite is true. The higher we start on the valuation ladder the higher the risk and the lower the return. Saying something is high risk or that it is low return in many cases is saying the same thing.  The lower we start on the valuation ladder the more upside the future can bring while also delivering less pain if things do not go our way.  This valuation based model is in direct opposition to the one that is used by the investment industry.

Volatility Produces Opportunity Not Risk 

We discussed earlier how almost no one complains about volatility when it is to the upside.  So maybe the only volatility that makes things risky is when market prices are falling.  But the section just above concerning the valuation ladder contradicts this as well.  If prices in the market are falling it means we are paying less for each dollar of cash flow. This actually reduces risk and increases the future upside.

As an example, lets say a stock is currently trading at $20.  Lets say we have done our own independent valuation and we find that we believe the underlying value of the business is also $20. In other words the stock is trading at fair value.

Lets look at the way we should evaluate the situation if the stock suddenly falls to $10.

Under traditional industry definition the volatility of this investment makes it very risky. It just fell 50%; that kind of volatility would definitely be seen as a negative by traditional analysis. In short, a stock that falls from $20 to $10 is seen as more risky if we consider volatility as risk.

However using the approach I have advocated we should not use recent market volatility as our definition of risk. Instead we should compare our estimated valuation of the underlying business to what we can buy it for in the market.  Notice what the 50% decline in the market price has created: it has created a disconnect between our estimated worth of the underlying investment ($20) and the price we can buy it for ($10).  Far from increasing risk, the recent volatility has created an opportunity to buy an asset for less than we think it is worth.  This decline has also decreased our risk. Before the fall, we had the possibility of losing $20 per share, while now the most we can lose is $10.  So the volatility that created the price decline has increased our potential for upside as well as decreased our downside.

In short in dealing with risk we should not consider how the current market price relates to other recent market prices, instead focus on how the current market price relates to the underlying worth of the investment.

This is the discussion of the valuation ladder put in to practice.  Price volatility that result in lower valuations increases potential future returns and lowers risk.  Market declines allow us to purchase at valuations that start us on lower rungs. Rather than viewing volatility as creating risk, visualize market volatility as moving us from one rung to another. Price volatility that moves a potential investment from a higher rung to a lower rung is actually a good thing.

Volatility in the market that creates a disconnect between the value of the underlying investment and the price we can buy it for creates opportunity not risk.  In a somewhat perverse way, we need volatility in order to achieve long term success.  If everything was rationally priced, if nothing ever fluctuated, if there was never any disconnect between the worth of the underlying investment and the market price, then we as investors would have nothing to do. It’s only because of volatility that we find discounted valuations. It’s only because of volatility that we have  situations where the worth of the underlying investment substantially exceeds the market price.

Volatility Can Be Emotionally Difficult

Hopefully so far I have made a good case that volatility is not a good definition of risk.  Volatility is in fact a source of opportunity because it can create a disconnect between the underlying worth of the investment and its market price.  Market declines allow us to start at a lower rung of the valuation ladder.  Lower rungs of the valuation ladder allow us to achieve both higher return and lower risk.  But when met with volatility it seems like we are emotionally wired to feel the opposite.

It can be difficult to not let our short term emotions overpower our more disciplined analysis. Even though we can rationally see that market declines produce opportunities, we will likely feel like we should do what everyone else is doing and sell.  Price declines seem bad, and rising prices seem good.  But as we have seen rising prices that start us at higher rungs of the valuation ladder actually increases risk and lower potential returns. But this in not what our emotions will tell us.  Our emotions will tell us that the higher rungs of the valuation ladder are better. Other investors will tell us the same thing as well.  The investments that are popular will be the ones that will have been bid up to the highest valuations.

As prices rise, other investors will become more enthusiastic even though they do so to their own detriment. As prices decline, other investors will become more fearful exactly when they should be using the declines to look for opportunities.

Therefore when thinking about risk therefore are several things we should not rely on to tell us about risk.  We should ignore recent market volatility; we should ignore our own knee jerk emotions; we should ignore other investors.

When is risk the highest? It is exactly when no one thinks risk is present. When people believe nothing can go wrong, when everyone is excited and optimistic. This will be the time when everyone is bidding up valuations and as a result of these rising prices it will cause other investors to jump on the bandwagon as well. This is when we are at the highest rungs of the valuation ladder. Risk is high and returns are low.

When is something likely to be low risk?  It is likely to be after major volatility has brought prices down. It is likely when other investors are pessimistic and believe it is a poor investment. It is likely to be low risk even when your own emotions are producing uncomfortable feelings. Our own emotions are likely to be afflicted by the same errors as other investors. But we need to overcome our own emotional glitches and remember that market volatility creates the opportunity for disconnect between underling investment worth and the market price.  Lower valuations increase potential future returns and lower risk even though our emotions don’t think so.

Final Thoughts

Risk is the possibility of permanently losing money you have invested.  It is not the price fluctuations in the market; it is the the probability that you actually lose money permanently over your investment horizon.

I have argued that valuation is one of the primary tools we have to increase our probability of success.  When thinking about risk we should not compare the market price to other recent market prices, but rather we should compare the market price to the underlying worth of the investment. We should shift the focus of risk from market fluctuations to the merits of the underlying investment.

Mainstream thought says that volatility creates risk.  However as we have seen volatility creates opportunity as the disconnect widens between the underlying value of the investment and the market price.  Mainstream thought says that high risk comes with high returns.  However, from the valuation ladder we have seen that  high risk does not come with high returns.

Our choice is actually between 1) high risk/low return or 2) low risk/high return.

We should view risk not as volatility but rather within a probability framework.  We should do everything we can to tilt the odds in our favor. We should favor things that increase the probability of success and avoid things that increase the probability of failure. There are certain common actions that increase the possibility that investors will suffer a permanent loss of their money over the long term.

Therefore, in day to day practical terms risk includes:

1. Not knowing what you own.
2. Not Considering How the Investment Will Withstand Challenges in an Uncertain Future.
3. Overpaying For What You Buy
4. Owning Things Because Other People Own Them
5. Owning Things Because It Has Gone Up in Price and You Have a Fear of Missing Out
6. Assuming That Because Things Are Going Well It Means There Is Little Risk
7. Forgetting The Cyclical Nature of the World
8. Allowing Your Emotional Responses To Price Fluctuations To Drive Decisions
9. Thinking You Can Increase Return Simply By Taking On More Risk
10. Thinking You Can Reduce Risk Simply By Investing in Things That Are Seen As Less Volatile.