What Is Risk In Investing?

How do we manage investment risk? Let's illustrate it using $FND

source: Investor Weekly

To summarize, risk management in investing involves:

• Identifying all open-ended threats which cannot be eliminated;

• Approaching risk management in a probabilistic manner, not a targeted manner;

• Quantifying the possible losses in all risk scenarios materializing;

• Comparing the possible downside to the possible upside, and ensuring a sufficiently positive upside asymmetry exists.

You’ve probably heard that you need to have good risk management in investing. Amidst these trying markets, nowhere is such advice more relevant. Yet it can be confusing to identify what exactly it is you need to do to manage risk. So what actually is risk in investing?

We all know that risk isn’t volatility. This has already been explained to death, so I won’t repeat it here. Some of you may have heard that risk is the permanent loss of capital — which is true, but remains confusing. Still others might have heard that risk refers to the distribution of possibilities that your investment is exposed to.

In this article, I’ll explain what risk means in investing in layman’s terms. Hopefully, by the end of this article you’ll be able to expertly manage your investment risk exposure.

Firstly, risk refers to all open-ended threats which cannot be eliminated that your capital is exposed to. Yup, all of them. If that sounds like a gazillion things to keep track of, that’s exactly what it is. There’s no neat and tidy way to manage risk, no simple formula to boil risk down to. Buffett said that, “Risk comes from not knowing what you’re doing”, and so you need to be aware of all the macro and business risks that your shares are exposed to. Otherwise, it could lead to the permanent loss of capital.

In this article, I’m going to use FND (check out my previous article about them) to illustrate the concepts I’m describing. What are the material risks which FND faces? There’s the risk of higher interest rates from inflation. That could lead to lower Existing Home Sales, which FND’s business is sensitive to. FND also has seen lower comps from poorer turnover as sales growth declines. These are just examples of some of the risks that FND is facing which you need to be aware of as an investor.

Notice how you can’t just boil all of them down to a simple formula. The intelligent investor is privy to all the individual risks which occur, and has a mental model that keeps track of all of them in his head. That’s what risk management in investing requires.

The second dimension of risk involves the distribution of possibilities that an investment is exposed to. Think about it this way — when you’re looking back on an investment outcome that has already materialized with the benefit of hindsight, there’s no risk because the outcome has already materialized. But when you’re looking forward towards the future before an investment outcome has materialized (e.g. when making an investment decision), there is a lot of possible risk which could yet materialize. You shouldn’t be trying to pinpoint exactly what is going to happen (e.g. setting target prices) because you just don’t know. Rather, you have to consider all the possible outcomes that could happen to your investment.

Let’s illustrate this using FND again. Most sellside analysts would seek to identify exactly what would happen to FND in 12 months time, so that they can figure out its exact future share price trajectory (i.e. target price). But good risk management involves doing more than that — it involves asking yourself what are all the possible outcomes which could happen?

Could FND face greater pressure from higher inflation and therefore higher interest rates? Could FND see depressed sales from declining Existing Home Sales? Could comps take a turn for the worse due to lower housing turnover? Good risk management involves keeping track of all the possibilities in your head, and doesn’t limit itself to just trying to identify one future outcome.

Then, we come to the third dimension of risk: quantifying risk. Now that you have identified all the possible risks which could happen, you need to put a number to them. How much could FND’s share price fall by if higher interest rates materialize in the worst-case scenario?

In my view, FND’s sales and earnings have already hit rock bottom and shouldn’t worsen significantly even if interest rates should rise and Existing Home Sales fall further. What could happen is that FND faces further multiple compression, from 27x PE today to perhaps 20x PE, to reflect declining growth. They’re still going to be growing revenues by about 10%-20% (see my FND article for their fundamentals), so 20x PE sounds like a decent floor for their valuation. That puts the possible downside at about 25% (1-20/27).

See how I quantified the risk? Now you need to do that for all possible downside outcomes for all your positions in your portfolio. This is what risk management involves.

Finally, we come to the fourth dimension of risk management: comparing risk to potential returns. In other words, we need to figure out the risk:reward and see if there is enough asymmetrical upside in the position.

So what’s the upside for FND? In my view, I think it’s quite possible that FND reverts back to its historical highs of $100/share if the macro picture improves and its fundamentals return to health. That represents a nearly 100% upside relative to FND’s current share price of $51.

Thus, the risk reward ratio is 25:100, or 1:4. You can’t eliminate all risk, but you can ensure that you only touch an investment if the potential return far exceeds the potential risk. I typically aim for a 1:3 ratio in all my investments, which should result in an aggregate portfolio risk:reward asymmetry of 1:3 as well. In the best-case scenario, this means your winners triple while your losers only fall by a factor of 1x.

To summarize, risk management in investing involves:

• Identifying all open-ended threats which cannot be eliminated;

• Approaching risk management in a probabilistic manner, not a targeted manner;

• Quantifying the possible losses in all risk scenarios materializing;

• Comparing the possible downside to the possible upside, and ensuring a sufficiently positive upside asymmetry exists.

Congratulations, you’ve just understood risk management in investing! It’s not something you can boil down to a formula, but rather just a very common sense matter to manage. Happy investing!