What does “Risk” mean in investing? 

Focus on the downside, let the upside take care of itself

10 Ways to Reduce Investment Risk While Building Wealth - Retire Certain

Howard Marks uses the analogy of a construction worker building a house to describe portfolio risk management. 

A good construction worker ensures that the house is built up to code, regardless of whether an earthquake happens or not. A bad construction worker, however, tries to optimise his building materials for the chance of an earthquake happening. Given that the chance of an earthquake happening is usually in the low single-digits, that means he tends to get away with saving a lot on the costs of building materials during good times.

However, the moment an earthquake happens, the house collapses and the entire house is lost (+ lives). But if no earthquake happens over the entire life of the house, it may seem like a waste of resources to ensure that the house is always built up to code. Still, that does not take away from the necessity of building a house to code at all times.

As such, risk management in investing should not be viewed through the lens of optimising for returns. Rather, it should be risk-focused - i.e. with the goal of putting a floor on potential losses, whether they actually happen or not. The goal is not to improve returns.

Consequently, good risk practitioners may be perceived as underperformers when those risks don’t materialize, as a result of lower returns. However, when those risks do materialise, the necessity of good risk management becomes painfully apparent. A 100% loss after a 100% gain, is still a 100% loss after all.

Hence Buffett’s quote about knowing who’s naked only when the tide goes out. In the long-term, a risk-focused approach is much more likely to result in higher gains than a return-focused approach. 

Therefore in investing, prioritise risk management over return management. Ensure that your house is built to code at all times, regardless of whether an earthquake actually happens or not. Similarly, ensure that your portfolio is able to withstand all shocks, whether portfolio risk actually materializes or not. Do not worry about the outperformance of others over you as a consequence of embracing unacceptable risk.

Elroy Dimson once said, “Risk means more things can happen than will happen”. Invest for what MIGHT happen, not necessarily what WILL happen. Optimize for probabilities, not outcomes. 

This is the essence of risk management in investing.

In this video, the famed investor Nassim Taleb further expounds on what constitutes intelligent risk-taking: https://youtu.be/4P47UTF0tZA&t=4m18s (click this link to jump to timestamp)

At the 4 minute and 18 second mark of the interview, he describes how one should embrace risk which leads to incremental opportunities - as long as they do not involve the “risk of ruin”. It is a common oversight of investors to perceive investment risk through the lens of a mean average, which ignores tail risks that could be ruinous. It is these risks that Taleb cautions us from embracing.

However, he does encourage the intelligent taking of risks which do not involve the risk of ruin, as embracing them does avail the investor to opportunities that may not otherwise be available. As the potential fallout from taking these risks is limited, it is subsequently possible to manage their potential fallout through other risk mitigation techniques. And even in the worst-case scenario, it would not lead to ruin for the investor.

From the above, we can infer 3 things:

  1. There are many risks in the future - but some or all of them may or may not materialize into outcomes. Hence, good risk management practices can lead to underperformance if those risks don’t materialize.

  2. Despite this, one should still always be prepared against the “risk of ruin” - even if it should come at the expense of returns.

  3. Intelligent risk-taking of risks which do not involve the “risk of ruin” should maximize risk:reward over the long-term.

In sum, the optimal investment approach is to apply a bottom-up risk-focused approach (in contrast to a top-down return-focused approach). Risks should ideally be minimized as much as possible; however not to the extent that it increases risk in the other direction (e.g. the absence of upside) - hence a balance of risks needs to be found. Intelligent risk-taking should be encouraged whenever the potential return justifies risk-taking, but only if it doesn’t lead to the risk of ruin.

The idea being that even when best practices are applied, outcomes cannot be secured with 100% probability - due to the investor’s inability to predict which potential risks will materialize, owing to the sheer scale of permutations involved in global markets. Hence, a top-down approach which attempts to secure outcomes should be eschewed, in favor of a bottom-up approach which allows pivoting to different goals when the wider environment requires it. This inevitably means that failure to achieve pre-determined objectives is possible, but at least the risk of ruin is avoided at all times.

In consideration of what is within the investor’s control, this is arguably the best that he can do even if it means he may not always achieve the best returns in the short-term. However, over the long-term, the application of the normal distribution of probabilities over many years of above-average returns should still enable him to achieve top-quartile returns.

Enter your email below to get our next research article in your inbox!