RISK: The Definitive Value Investing Definition
What does Buffett really mean by "Rule No. 1: Never Lose Money"?
In this article, I will prove why:
1. Definition of Risk = Uncertainty
2. Application of Risk Management = Margin of SafetyMost followers of Buffett and value investing will know that Volatility doesn’t equal Risk. The reasons for this are already extremely well-documented elsewhere, so I won’t reinvent the wheel here. However, most value investors still find it hard to provide a satisfactory answer to what Risk actually does mean. Some might say that Risk refers to the permanent loss of capital, but are unable to truly conceptualize it beyond that as a matter of real-life practice.
There’s a saying that a master of a particular topic is able to explain something complex in such a way that even a 5 year old can understand. Anecdotally, it has been my observation that most self-identifying value investors (myself included previously) cannot explain what Risk means according to value investing to a 5 year old.
However, I have finally managed to do so. In this article, I’ll be doing exactly that — providing a satisfactory answer to what the definition of Risk is in a value investing context. It won’t exactly be ELI5, but at least it’ll be a highly satisfactory explanation with an easy-to-follow logical flow that doesn’t involve any complicated insider jargon.
There’s a reason why Risk in an investment context is so difficult to explain in simple terms, beyond the traditional definition of share price volatility. Volatility benefits from being a standardized metric — it’s a highly objective measurement, and everyone can agree on what it is.
In contrast, the true concept of Risk according to value investing is something that cannot be explained in isolation, as it requires the understanding of certain foundational premises that are not found in the status quo. And since these premises aren’t part of our investment/financial status quo, trying to explain Risk according to the value investing definition in their absence ends up falling flat.
Hence in order to answer the question “What Is The Definition of Risk?”, I will first have to lay down these premises before moving on to answering the actual question. And because these would serve as mere platitudes without further expounding themselves, I’ll also have to explain what the premises mean — so that readers have the correct context when I move on to answer the original question of “What Is Risk?”. These 4 premises are:
The 4 Premises:
1. Buffett's Rule No. 1: Never Lose Money
2. Risk = quantifiable downside, Uncertainty = unquantifiable downside
3. Only accept incremental risk where incremental reward can be justified
4. Asymmetric Risk:Reward in Efficient MarketsBy understanding each of these premises individually, we can pull all of them together and connect the dots between them to provide sufficient environmental context to the original question of “What Is Risk?”. Subsequently, we shall explore why the application of proper risk management in markets boils down to Margin of Safety.
Understanding The 4 Premises
1. Buffett's Rule No. 1: Never Lose MoneyMany value investors have heard of this phrase before — it is followed by the humorous “Rule No. 2: Never Forget Rule No. 1”. However, ask most people what Buffett actually means by this in real-life practice, and one usually gets a ‘deer in the headlights’ look.
The reason for this reaction is because the implication of this quote is genuinely confusing — is Buffett implying that we should simply invest in cash? “Never Lose Money” implies accepting zero investment risk — which most people agree equals cash as an investment. However, the automatic assumption of holding cash is to also accept zero investment return (without getting into semantics). Hence, the natural inference is that Buffett’s advice is to invest in cash — which is even more of a head scratcher.
So where is Buffett actually coming from with this quote? Here’s the trick — Buffett’s Rule No. 1 is not meant to be a goal, or an end-objective. Rather, it is merely meant to serve as a starting point. In other words, Buffett is not telling us to “Never Lose Money” as a goal (e.g. hold cash). Rather, “Never Lose Money” is simply the starting point, or the baseline for investment decisions.
What do I mean by that? Consider how most stock market investors think about investment risk. As stocks represent pieces of businesses, the automatic assumption is to assign business level-risk tolerance to equity investment decisions. Unfortunately for most laymen, this amounts to taking unknown (i.e. maximum) risk at the outset — and subsequently figuring it out. (i.e. “just do it”)
In contrast, what Buffett’s Rule No. 1 is trying to teach us is that our baseline for investment decision-making (or starting point) should be to “Never Lose Money”. From there, we can consider Premise No. 3 — which is to “only accept incremental risk where incremental return can be justified” (we’ll dive into that later, as we also need context from Premise No. 2 to fully flesh it out).
However, the important distinction to make at this point is that Buffett’s starting point or baseline when making investment decisions stands in stark contrast to the entrepreneurial status quo. The former’s starting point is to “Never Lose Money”; whereas the latter’s starting point is to “Take Maximum Risk and Justify Yourself”. On the surface, this difference alone might not seem to be very consequential without further context from the other premises. However, even in isolation, notice how it leads one to approach investment decisions very different? Following either approach leads to a preference for incredibly different types of stocks, even at this starting point.
2. Risk = quantifiable downside, Uncertainty = unquantifiable downsidePremise No. 2 is simply the standard definition of Risk & Uncertainty in traditional finance doctrine. But what do they actually mean?
Consider the following analogy. If you are in a room with a ceiling fan, look up at the exposed spinning blades of death that you never think twice about. Why are we so nonchalant about the risk of possible decapitation from an accidental fan blade mishap? That’s because the ceiling fan was invented nearly 200 years ago in 1882 — and since then, we have collected almost 200 years of data which empirically prove that using ceiling fans is safe. Thus, the downside is quantifiable (Risk), and we find comfort in accepting the low probability of said downside — even if the level of risk is unacceptable were it to materialize (i.e. decapitation).
However, consider what this contraption might have seemed like to someone living in 1882 — it’d probably appear considerably closer to the aforementioned description of “exposed spinning blades of death” than “ceiling fan”. This is because at the time, society did not have enough safety data from using ceiling fans. And since the potential downside of decapitation was unacceptably large, the unquantifiable downside resulted in heightened levels of Uncertainty.
Now consider another scenario. Think back to roughly 5 years ago, when self-driving cars were first legally allowed to drive on public roads in certain states. Despite there being countless robust scientific studies on how self-driving cars were safer than human-driven cars (due to the absence of human error), the general public was horrified enough at the prospect that it almost became a political topic. Why? With the benefit of hindsight, we can say that the safety data from 5 years ago was not doctored. However, in the absence of enough actual experience with self-driving cars on public roads, the probabilities of said downside were unquantifiable. And when that downside potentially involved death, that heightened level of Uncertainty became too much to bear.
At the heart of it, the difference between Risk and Uncertainty (according to standard financial definitions) is simply the ability to estimate probabilities of occurrence. In both of the scenarios above, the downside had it materialized was equally unacceptable (death). However, there was a huge difference between how humans perceive risk when the probability of occurrence is quantifiable as Risk vs. unquantifiable as Uncertainty. When the downside is quantifiable, we are capable of making logical decisions about whether that risk is worth taking. Conversely, when the downside is unquantifiable, our lizard brains tend to go to the opposite extreme and assume infinite downside exists. Naturally, this leads us to avoid unquantifiable downside (Uncertainty) at all costs.
Let’s use a market example to illustrate. 10Y US Treasuries are currently offering roughly 4% yields. Since US Treasuries are generally considered risk-free if held-to-maturity, the downside is quantifiable at 0%. Even if we were to consider something else which does have some risk — such as Apple bonds with a current yield of 4.475% — the downside as represented by default risk would still be largely of the quantifiable variety, by virtue of Apple having more cash than some countries.
Now let’s consider something slightly less benign. Alibaba’s 2057 bonds currently sport a Yield-to-Worst of 5.5%. If we merely consider the factors that are within Alibaba’s management’s control, most entrepreneurs would agree that Alibaba’s business as the largest e-commerce company in China is highly cash flow generative and therefore would make for a pretty safe fixed income investment. This is quantifiable risk, and the high degree of quantifiability is something our logical minds can handle.
However, most of those same people considering such an investment would also ponder on the unquantifiable downside — such as wider China macro, geopolitics, etc. And even though few people believe that Alibaba could conceivably default on its bonds even after 35 years, the inability to quantify the downside is enough to put many investors off. This is because: 1) the downside of potential default if it materialized is unacceptably large, and 2) our lizard brains are just not wired to handle Uncertainty, and therefore we stay away from such unquantifiable downside at any cost. At any cost.
P.S. This is also why our lizard brains fall for temporary promotional retail prices, as well as FOMO on stock prices. The unquantifiable downside of missing out on a limited-time opportunity pushes us to fear the Uncertainty involved (as it represents unquantifiable downside) — and we do everything in our power to stay away from such Uncertainty. This is why Buffett says that successful investing requires the right temperament.
Hence, we can see from the two illustrations above how investment downside can basically be described in two ways — quantifiable (Risk) and unquantifiable (Uncertainty). Try and visualize it on a chart this way: any potential investment downside represents the negative territory of a chart below the zero risk baseline (x-axis). We can visualize quantifiable Risk as starting from zero on the y-axis, and peeling downwards from there. However, at some point in negative territory, this Risk hits a floor — and is continued by unquantifiable Uncertainty. Due to its unquantifiable nature, Uncertainty would persist into negative infinity on the y-axis.
3. Only accept incremental risk where incremental reward can be justifiedNow that we’ve fleshed out the aforementioned two premises, we can truly begin to understand Premise No. 3. This premise actually has its own premise — i.e. Premise No. 1, which is that the baseline or starting point for investment decision-making should be at the zero risk baseline. Subsequently, any incremental risk should only be entertained where incremental reward can be justified.
It’s actually easier to describe this theory by providing an illustration. Simply put, one should only accept 20% risk from the zero risk baseline if 20% returns can be justified. Let’s revisit the aforementioned scenario of 10Y US Treasuries, which are currently offering 4% yields. If we observe Buffett’s Rule No. 1 (Premise No. 1), the associated acceptable level of permanent downside should be a maximum of 4%. And since US Treasuries are generally considered risk-free if held-to-maturity, one could argue that this qualifies Buffett’s criteria.
Of course, stock investors rarely have the luxury of having such objective market prices to measure their downside. Any business investment naturally involves possible downside — and measuring the degree of that downside is always going to be a subjective exercise. However, the principle of Premise No. 3 remains true despite that. Any given level of subjectively-determined downside from the zero risk baseline should only be entertained if the subjectively-determined upside can be justified.
The importance of this become apparent when we tie it back to Premise No. 1 (“Never Lose Money”). If our starting point is the zero risk baseline, then we can only accept incremental risk where the incremental return can be justified from that same baseline. This stands in stark contrast to how most equity investors view the starting point for their investment decisions, which is to accept an unknown level of risk (i.e. maximum) for a merely acceptable level of incremental return. In isolation, Premise No. 3 might just seem like common sense — but it becomes extremely valuable once we tie it with Premise No. 4 below.
However, even this subjective determination of downside is still only describing quantifiable downside (Risk), rather than unquantifiable downside (Uncertainty). If we assume that markets are efficient, any potential return is going to be accurately matched by the same quantum of risk in terms of efficient market pricing.
Thus the question begs: how does one generate excess returns in efficient markets?
4. Asymmetric Risk:Reward in Efficient MarketsIn this section, we shall assume that market are efficient for simplicity’s sake. In efficient markets, any degree of incremental return is going to be matched by the same degree of incremental risk (starting from the zero risk baseline). If so, how do we actually generate excess return (alpha) in efficient markets?
This is where we pull everything we’ve learned thus far together to form a cohesive picture:
Premise No. 1 demonstrates that the starting point for our investment decisions should be the zero risk baseline, not the maximum/unknown risk baseline of the business status quo.
Premise No. 2 demonstrates how quantifiable downside (Risk) is considered acceptable by human nature; while our lizard brains intuitively shy away from unquantifiable downside (Uncertainty) at any cost.
Premise No. 3 teaches us that any incremental risk (from the zero risk baseline of Premise No. 1) should only be considered where incremental return can be justified.
This brings us to Premise No. 4. If we connect the dots between Premises 1-3, we will intuitively recognize that the only way to generate excess return in efficient markets is to accept Uncertainty (i.e. unquantifiable downside) in our investment decision-making.
This is because Uncertainty, by virtue of its unquantifiable nature, creates opportunities for mispricings — due to the lizard brain phenomenon of staying away from unquantifiable downsides at any cost. When the status quo is to stay away from an asset at any cost, it is inherently logical that such an asset could invite mispricings… even in efficient markets!
If so, then it becomes mandatory for the value investor to entertain Uncertainty (unquantifiable downside) in their investments if they want to generate excess returns in efficient markets. Efficient markets don’t leave money on the table, so any risk or reward that can be quantified is likely already priced in — and investors can’t generate excess returns by investing in an asset that is already trading at fair value. However, any risk or reward that cannot be quantified also cannot be priced in, efficient markets notwithstanding. Hence, by accepting Uncertainty as part of their investment process (i.e. mental model), value investors are giving themselves the opportunity to generate excess returns.
This is what the commonly mentioned phrase “Equity investors are paid to take risks” is referring to. Nobody leaves money on the table in efficient markets — hence the only way to generate excess returns is by embracing uncertainty, which markets do reward because of how inherently uncomfortable it is. The social contract of capitalism is that it both rewards and punishes those who embrace uncertainty on behalf of society — with both fortune and misfortune favoring the bold.
Also, notice how starkly different this approach is from the traditional status quo of forecasting precise outcomes in stock markets? If you accept Uncertainty (unquantifiable downside) in your investments, by definition it means that forecasting future outcomes accurately is impossible — by virtue of the downside being unquantifiable.
With everything we’ve discussed as context, we can finally answer our original question: WHAT IS THE PROPER DEFINITION OF RISK? While we have been using the standard definitions of Risk and Uncertainty so far (i.e. quantifiable vs. unquantifiable downside), the definition of Risk according to Value Investing as per our original question refers rather to the permanent loss of capital. By laying out the aforementioned 4 premises and connecting the dots between them, we can see how the value investing definition of Risk = the standard definition of Uncertainty (i.e. unquantifiable downside). Hence, why I said above that the definition of RISK = UNCERTAINTY.
And lest you think I’m just making things up, allow me to wrap up this section with a few investment examples from the Oracle himself which demonstrate this nature of investing. Those who are familiar with Buffett’s pillar investments will recognize that he never attempted to forecast future outcomes accurately. Consider his now legendary investments in the following stocks, which were acquired during times of great Uncertainty:
American Express in 1963 (acquired amidst the infamous Salad Oil Scandal);
Washington Post in 1973 (acquired amidst regulator threats to pull their broadcasting licenses in 1971);
GEICO in 1976 (acquired on the brink of bankruptcy);
Coca-Cola in 1988 (acquired following lackluster diversification efforts and amidst the stock market crash of 1987);
Wells Fargo in 1990 (acquired amidst the banking panic following the 1990 Californian earthquake),
Apple in 2016 (first stake acquired amidst growth concerns following saturation of the China iPhone market)
Most of these investments were made during times of heightened uncertainty, where even Buffett would not have been able to predict their future outcomes with certainty. What we can conclusively say, however, is that he invested in them despite their heightened Uncertainty — because that gave him the opportunity to take advantage of mispricings, even in efficient markets.
Application of Risk Management: Margin of Safety
However, simply investing into Uncertainty for its own sake is no different from trying to catch a falling knife. So how do we as Intelligent Investors square that circle — or in other words, how do we avoid loss outcomes despite it being mandatory to invest into Uncertainty (unquantifiable downside) in order to generate excess returns in efficient markets?
The answer is Margin of Safety. Going back to the example from Premise No. 3, we should only entertain incremental risk where incremental return can be justified. Hence, when investing in situations where the downside is quantifiable (Risk), we should only entertain 20% incremental risk from the zero risk baseline if 20% incremental returns can be justified.
However, if as aforementioned it is mandatory to invest in situations where the downside is unquantifiable (Uncertainty) in order to generate excess returns, then we must give ourselves an incremental Margin of Safety on top of the standard risk:reward ratio. E.g. in the same example above, an investment with 20% incremental risk should only be entertained if 40% incremental returns can be justified. This is simply the standard value investing description of Margin of Safety.
Of course, when I say 40% upside/return, what it actually looks like in real-life is a 40% margin of safety from fair value. Don’t get confused by the opposite trajectories of “upside/return” vs. “margin of safety” — if you think that the quantifiable downside (Risk) is potentially 20%, then the Margin of Safety requirement should double your price gap to at least a 40% lower price from fair value to account for unquantifiable downside (Uncertainty).
In this way, you can safely entertain Uncertainty (unquantifiable downside) as a mandatory condition of generating excess returns in efficient markets. This echoes what Seth Klarman states in the following quote in his namesake book:
“A margin of safety is necessary because valuation is an imprecise art, the future is unpredictable, and investors are human and do make mistakes.” — Seth Klarman in his book, Margin of Safety.
It is also why the Father of Value Investing, Benjamin Graham, has the following to say on the topic:
And finally, it is also why Buffett’s Rule No. 1 is “Never Lose Money”. What is that if not an advocacy of the timeless principle of Margin of Safety?
In this way, we have not only managed to define what Risk means to the value investor, but also how to put it into real-life practice. At the very least, it’s something that can be explained to a 5 year old, right?
Learn more about Margin of Safety
I have actually written extensively about Margin of Safety in my previous value investing articles. If you’re interested to learn more about it, please head over to them by clicking the links below:
Aaron, this is great! I really enjoy reading about value investing concepts first and foremost. Sometimes, an example from a real company is helpful, but I really strongly prefer overarching frameworks like this. In my own quest to understand finance and investing, I've gained the most by researching (and occasionally writing) about these big concepts.
This takes the right approach, and you have it here.