The Tao of Risk (inspired by Howard Marks)

Risk & Price-Paid
The biggest Risk to an investor results from the price he pays for an asset.

  • “Market prices” are a result of the psychology and the behavior of investors.
  • Hence the psychology and the behavior of the markets investors create or reduce the most Risk.
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Gold, not so “golden” bought at high prices.
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Copper, an investor’s “gold” at low prices.

 

The Movement of Markets

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  1. Let us say the Race-Track represents the Economy. It does not fluctuate or change much. (a 5% drop in GDP is considered massive).
  2. Race-Participants then represent Businesses. They comprise “the horses and their jockeys”. Business profits fluctuate considerably more than the economy, because of their operating and financial leverage. However these can be mitigated and are generally limited in their extremities.
  3. The Race-track Audience, meaning the bettors and the speculators represent ‘Mr Market’, meaning the investors along with their psychology and their behavioral biases. These have no limits to their fluctuations and swings. They represent the attitude of investors towards risk. Crazy bullish at times and desperately bearish at others. Their wild fluctuations make those of the Economy and the Businesses to appear mild.

Just as the psychology of race-track bettors contribute most to the movement and changes of the track’s betting odds, so does investor psychology and moods contribute most to the movement of markets and its prices.

Behavioral Perversity and Risk
Investors’ behavior contribute most to market movements. They also contribute most to risk as a result of a ‘perverse’ behavior. Here’s how:
The riskiest thing in the investment world is the belief that there’s no risk. On the other hand, a high level of risk consciousness tends to mitigate risk. This is called the “perversity of risk.”

  • Jill Fredston, an expert on avalanches, has observed that “better safety gear can entice climbers to take more risk – making them in fact less safe.”
  • When all traffic controls were removed from the town of Drachten, Holland, traffic flow doubled and fatal accidents fell to zero, presumably because people drove more carefully.

So improvements in safety equipment can be neutralized by human behavior, and driving can become safer despite the removal of safety equipment. It all depends on how the participants behave. An Urdu couplet by the timeless Asad-ullah Khan Ghalib captures it well:

Khudaaya! Jazba-e-dil ki magar taaseer ulti hai
Ke jitna kheenchta hoon aur khinchta jaaey hai mujh se


Action
: Act contrary to this perverse behavior. Remember Warren Buffett’s dictum: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
Becoming more and less risk averse at the right time is a great way to enhance investment performance. Doing it at the wrong time – like most people do – can have a terrible effect on results. When people love an investment, be cautious. When they hate them, turn aggressive. In bad times securities can often be bought at prices that understate their merits. And in good times securities can be sold at prices that overstate their potential. And yet, most people are impelled to buy euphorically when the cycle drives prices up and to sell in panic when it drives prices down. Always keep gauging the “market’s psychology” and your own too.

The Tao of Risk:
1. Risk is not Volatility. Risk is not Uncertainty.
2. Risk is Price paid. When paid above Value, Risk is high. When paid below Value, risk is reduced.
3. Perversity of Risk. Its riskiest when you think that the risk is low. Conversely, risk reduces when you think that its high.


Risk vs Reward

Traditional risk-analysis defines a direct and a proportional relation between Risk and Reward. As risk increases so should reward. A higher risk should result into a higher reward and vice-versa. Value investing does not deny this relation and agrees it holds true mostly, but not always.

Why the exception? Answer: Human Psychology. The market is a result of actions of both human rationality and human emotions. It is a product of the rational and the irrational behavior of market participants even when they possess the same information and similar skills to analyze that information and while having the same incentives. It is human emotions, its behavioral biases and irrationality that often create the exceptions to this “efficient market hypotheses” which “occasionally (though not always)” flips the traditional risk-reward relation on its head.

Consider Warren Buffett’s take on this:

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Value Investors (VIs) choose: “Lower Risks, Higher Rewards.”

 

Fat-Pitch Investing

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VI’s choose to face lots and lots of pitches. When a pitch falls in the VI-ZONE (red zone) it qualifies as a “fat pitch” and deserves a batter’s “swing”. Else it deserves a simple “pass”. VI’s patiently wait for a fat pitch and when faced with the rare fat pitch they swing and swing hard.

More so, they try to seek out pitchers against whom the likelihood of the fat pitch occurring is high. This has 2 advantages. It reduces the batter’s own risk of a making a mistake of a bad swing. And more importantly, “time” (a precious, scarce and a finite resource) is not wasted in evaluating lean pitches or “passes”. So we want fat pitches and we want to look in places and situations where we find lots of them.

The keys to successful value investing then are:

  1. Face and evaluate lots and lots of pitches. Turn lots of pebbles. Evaluates lots investment opportunities.
  2. Choose to bat against weak pitchers whereby the chances of receiving fat pitches are more numerous. Choose to play where you have an Edge against your opponents.

In fishing parlance, choose the right “fishing day and the hour” and right “fishing spot”. VI-ZONE pitches by definition are best found when the crowd has given up fishing (read bear markets) and WHERE the crowd has chosen NOT to fish (read “market rejects, discards.”)

The excerpt below captures all of the above points on RISK:
The academic world still insists on teaching that financial markets are largely efficient, with perhaps a few minor anomalies (such as the “January effect”) that give tenure-seeking finance professors something to research. Efficient market theory holds that financial markets are efficient because investors are rational. They will immediately and accurately assess all available information and act on it, thereby rapidly reflecting it in the pricing of securities. Conceptually, this picture makes sense. In practice, it simply doesn’t hold up.

Despite the number of actual “rocket scientists” who have flocked to the investment business, securities prices aren’t subject to Newtonian principles, only behavioral ones. Most of us like a stock more when it has risen in price and less when it has fallen, even though this is antithetical to its investment merits, which can only be determined by comparing price to underlying value. Investors emotionally pile in on good news, and rush for the exits on bad, frequently causing prices to overshoot. Value investors know–although efficient market believers fail to comprehend–that the underlying value of a security is distinguishable from its daily market price, which is set by the whim of buyers and sellers, as are the prices of rare art and other collectibles. Investors must remember– although at the peak of emotion they sometimes forget–that securities are fractional interests in, or claims on, businesses that have their own assets and cash flows. They have (usually) ongoing business value and (at least hypothetically) a liquidation value. The herd can irrationally lose sight of the underlying assets or long-term prospects of a business when it focuses on price movements triggered by disappointing quarterly results or the latest overheated social networking IPO. Often, a company’s share price fluctuates significantly even in the absence of fundamental developments, such as when a sizeable seller needs cash quickly. – Seth Klarman

– Husain Kothari
16th January, 2013

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