Biggest concern for all investors and savers --- RISK & RISK ASSESSMENT

Post by Admin | February 06, 2017 | Comments

It is unnatural to find an investor or saver, who is not concerned about the risk of investment in stock market. Courtesy, poor financial literacy and unscrupulous selling by many financial product sales people, general perception about risk of losing money or not getting adequate return from stocks are still very high in our country and justifiably so. And it is commonly believed that without taking high risks high returns can't be generated. 

Here I would try to discuss, based on my years of reading Howard Marks (HM), that how risk is perceived by common investors and how it is different from actual, real or potential risk of losing money in stock market investment. So, does high risk mean high return? And can anyone generate it consistently taking high risks?

Firstly, Howard Marks was quite clear that everyone can't be a successful investor just by learning investment ... There is no simple, step by step learning process for investment. It needs second level thinking and insights which is not common, can't be taught and requires massive mental workload. Success of investing is an anti-thesis of simple.... Only three types of people think investment success is simple..... a) Those who teach investing; b) some well-intentioned practitioners who overestimate the extent to which they are in control and c) Those who simply don't fathom the complexity of the subject. Who in HM words are "first level thinkers".

All investors can't beat the market as collectively they constitute the market. To quote HM.... "Many people are misled into believing that everyone can be a successful investor. Not everyone can. But the good news is that prevalence of first level thinkers increases the returns available to second level thinkers."

Now, what he really means by second level thinking?

Here what he primarily means is the ability to go against the consensus opinion with clear and unbiased understanding of the merits of the “consensus opinion”. It doesn’t mean to be eccentric or egoist but to ask questions which most people possibly are not asking or started believing that the relevance of those questions are no more valid since nobody else is asking too.

Biggest RISK of investment comes when everyone thinks market can’t go down or when everyone thinks market can only go down. Very frequently, we see these collective euphoria or despair engulfing us. There are times when all your sensory organs are bombarded with positive news from all corners (party won’t end ever!) or with negative news of impending collapse of financial system (party can never start ever again!).

In the first case you lose money by believing the story and in second case you lose opportunity by fearing too much. If it happens to you and people around you often, then the right question for you to ask is “Who are on the other side of the trade?” “What they knew which I don’t?” Guess you yourself would get an idea of a “second level thinker” by asking these first level questions!! Both sides of the trade have same sets of information, but a “second level thinker” process the information differently. Possibly he or she is on the other side of your trade.

Next, another type of risk comes from our general day to day observational bias that “if something is costly, it must be good” or “if something is good, it must be costly”. For our daily life, both assumptions work for us in very useful ways to rank things and to value things…. But in equity investment, where collective emotion of participants play most important role in determining price of something, this assumption is often flawed. Many times, people quote a price for something much beyond its intrinsic worth and in other times they price it much less than its intrinsic worth. Here intrinsic worth mean the range of possible future cash flows from a given investment, which I am referring as actual “Value” of an investment for which you paid a “Price” while buying an equity. “Value” and “Price” mismatch happens like a see-saw in market not very infrequently.

So, risk of investment is not constant --- it varies with the perception of risk others have about the situation --- To be successful consistently, you need to think counterintuitively consistently for long term success.

But the most important question remain unanswered which is --- How to determine the “possible” future cash flows of a given investment and how to value it with reasonable approximation?” --- Determination of this is not a part of risk but your ability to understand the business and its present value which is not a part of risk analysis. We may cover the broad pointers, without any financial jargon, in some other time.

So, in a nutshell, what HM tried to convey is “risk and return” are not two directly related stuff …. One doesn’t need to take higher risk to generate higher return and rather higher return can be generated when everybody else believes the risk is very high. History of successful investment unfailingly shown it over the years.

There are other very important learnings from Howard Marks writing on risks and we plan to cover it sometime soon.

Thanks for reading and look forward for your valued opinions.


6th February 2017


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