Risk has a long list of definitions that make it unnecessarily confusing. Peter Bernstein sees risk as “the consequences of being wrong.” That’s a version I can get behind.
He contributed it to a great discussion with James Montier on how the different definitions of risks fit together, mainly whether volatility fits in and what it means for investing.
Ironically, Bernstein can see volatility as risk from a behavioral standpoint (hardly mathematical) because of the queasy feeling it creates. Montier sees volatility as opportunity.
In a sense, they’re both right. Volatility is the catalyst to a good or bad decision. The decision introduces the potential for risk — learned only in hindsight from the outcome.
Their discussion offers some food for thought:
Q: …earlier investment thinkers, such as Ben Graham and Gerald Loeb, also considered risk. They perhaps also had a better grasp of the multifaceted nature of market risk.
Peter: Yes, that’s what gives their works lasting importance. They talk about the consequences of being wrong and how you deal with that. That’s what risk is really all about. I think risk control was more central to Gerald Loeb’s thinking, because he says you should only invest a little bit of your money, but invest it very aggressively. So his consideration of risk is much more built-in than it is with Graham. Granted, Graham says one of the attractions of value investing is that it’s a low-risk strategy, but that’s different…
James: …This aspect of risk is interesting. What I would say is that Ben Graham defined risk in a way that is still used by deep value investors, like Tweedy Browne. In The Little Book of Value Investing, Christopher H. Browne talks a lot about how risk is defined in terms of business risk. It is the risk of buying a bad business. Whereas, I think the problem with a lot of the financial theory is that, in it, risk is equated to price volatility. It’s that — the equation of price volatility to risk — that is probably one of the worst aspects of modern finance. It’s why risk really is a four-letter word as it’s used in finance, because it misleads. Price volatility is, of course, what creates the opportunities for us — as well as, obviously, inhibiting a large number of investors from actually exploiting those opportunities.
Peter:..There are two sides to it. You’re right, volatility presents opportunities. But the meaning of risk itself is opportunity. It means we don’t know what’s going to happen, but just because we don’t know doesn’t mean that what’s going to happen is necessarily bad. So risk-taking is a positive step, risk management is a negative step, but both things are going on there and I don’t think that there has to be a confusion between them. For a longer-term investor, volatility is opportunity, no question about it. For a trader, it’s a problem if he’s wrong. But there’s another element of volatility that I think is important. It is a proxy for risk in the sense that it hits you in the gut. When the market is jumping around, it’s a lot different owning stocks than owning Treasury bills. It is an entirely different experience. If the market gets more volatile, we worry… No matter how calm you are, no matter how long-term an investor you are, no matter what your horizons, when the market is jumping around, you feel uncertainty in your gut and it’s hard to resist that. So I don’t think volatility is an altogether irrelevant proxy for risk, even though — to a cool, dispassionate investor with a long-term time horizon — volatility is wonderful.
Q: Shouldn’t you refine that a bit, Peter? Volatility only hits you in the gut when it’s going against you.
Peter: …Aside from its mathematical malleability, which has been very useful to the theorists, volatility creates a greater sense of uncertainty than you have when things are smooching along and you think, “Oh, everything is fine.” So I don’t think volatility is irrelevant.
Q: …If all those calculations are based on the assumptions that are, at bottom, bankrupt — like equating risk and volatility — aren’t we just using all those fancy models to delude ourselves that we’re controlling risk?
Peter: If you’re going to seek out volatility because that’s where opportunity is, you don’t want your entire portfolio to be volatile, you only want to make volatile bets within it. You have to be sure that there’s some systematic arrangement of the bets that you make so that the portfolio risk in the total portfolio is not as volatile as the individual components. One of Markowitz’s great insights was precisely that. That you can take a lot of high-risk bets — as long as they’re not correlated — and come out fine. I don’t see what’s fraudulent about trying to do that.
Q: …The problem is with the measurement of “risk” and with the correlations. All sorts of “normally” uncorrelated bets have a way of becoming correlated at precisely the wrong time.
Peter: …As I said, the markets are macro-inefficient. They can go haywire. That is a matter that you deal with through your asset allocation in the first place, so that you don’t get killed if the totally unexpected hits you in the face… My own affairs are run that way because I know that extreme outcomes can happen and I don’t want to get killed. But that doesn’t mean that I’m not making bets in the middle of the portfolio somewhere.
James: I have a wonderful quote here, if you’re interested, from Ben Graham, and another from Maynard Keynes… But Ben once said, “The investor with a portfolio of sound stocks should expect their prices fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remenber that market quotations are there for his convenience, either to be taken advantage of, or to be ignored.” I think that people do get hooked up on what prices are doing, perhaps far too hooked up, or maybe we’ve reached a sort of final state of informational deluge where we actually can’t separate our noise from news anymore. But here’s the quotation from Keynes, which as promised is much shorter: “It is largely the fluctuations which throw up the bargains, and the uncertainty due to the fluctuations which prevents other people from taking advantage of them.” That one, to me, just sums up the whole essence of the investment problem. In order to actually be a half-decent investor, you have to do something that is different. Far too many people today are busy worrying about their tracking error and their distance from benchmarks, rather than worrying about whether they’re buying good or bad businesses at reasonable prices or at ridiculous ones.
‘Capital Ideas’ or ‘CRAP’?