Understanding Risk and Uncertainty


While I continue finalizing the 2011 update for the intrinsic value spreadsheets, updating the 2010 screen and my portfolio results, I’ve got a great guest piece for you today.

A short paper on risk and uncertainty written by my good friend Ernie. He also brought you How to Invest: Research and Valuation Process.

I believe this paper is his first revision, but it leads the reader into understanding the concept of risk and uncertainty applied to investing. I like it because it is very different to how main street and wall street define risk and uncertainty. To most, it is the same, but you and I know that it isn’t.

Here are some other posts related to risk you may also be interested in.

A Short Paper on Risk & Uncertainty by Ernie

Risk

Risk as it relates to investing is an event that unfolds to induce impairment or loss of capital.

There are many types of risk. To name a few, there are financial, market, economic, systemic and portfolio risk. Generally speaking, risk causes volatility in the stock market, but it doesn’t necessarily result in permanent loss of capital.

The risk that causes permanent loss of capital is the concentrated risk where multiple events combine together to form a negative lollapalooza. Much like a person carrying too many things with too much weight on his or her shoulders, sooner or later, they will fall to their knees impaired.

In the stock market, there are always two sides of the trade, one side will be right and the other will be wrong. There is always a reason why the seller on the other side of the trade is selling to the buyer. Both will assess risk to the investment differently so this means one will be right.

When a transaction takes place from a seller to the buyer, in effect, the seller is transferring risk to the buyer based on their own criteria of risk.

In other words, the seller is really thinking that “I cannot manage the risk anymore so I am transferring it to the buyer who thinks they can manage the risk better in this investment”. It is up to buyer to decide with their own sound reasoning and judgment that the risk can be managed to a profit.

The seller’s criteria of risk can be based on beta, some singular mandate or some flaw in their analysis and valuation which forces them to sell. The important thing to do is to differentiate the risk that causes volatility and the risk that causes permanent loss which is concentrated risk.

Uncertainty

Not far from concentrated risk is uncertainty.

Uncertainty as it relates to investing is the inability to assess the magnitude of a given outcome in which an event can take place.

Every event that unfolds has an outcome. These outcomes have varying levels of results because there are many different events that can transpire.

Uncertainty has a high and low.

When the strength of an outcome of an event can be fairly predicted, it is said that uncertainty is low. When uncertainty is low, capital has a very high probability of returning safely.

When the strength of an outcome of an event cannot be fairly predicted, then it is said that uncertainty becomes very high. When uncertainty is very high, capital has a very low probability of returning safely.

When concentrated risk is identified, bracing for uncertainty must be done. To brace for uncertainty, one has to take reliable information and reason out the possible outcomes using a kind of sensitivity analysis.

The kind of sensitivity analysis preferred is more of a qualitative than quantitative approach where a best case, base case and worst case scenario are determined. The point of doing a sensitivity analysis is to know generally what the security will be worth in each of these scenarios if concentrated risk that is identified were to play out.

In my opinion, risk and uncertainty cannot and should not be quantified. Risk and uncertainty should only be reasoned out based on sound judgment backed by information that has been reduced down to the reliable.

Risk and uncertainty go hand in hand, which means that both need to be managed together. The ability to identify concentrations of risk and knowing the magnitude of any outcome should profitably reward the investor for taking low risk.

When it comes to risk and uncertainty, there truly are no extra points for degree of difficulty.

The extra points go to those who don’t lose money since compounding works for them powerfully. It is absolutely imperative not to have a down year because the time value of money will go against you and you will lose the compounding power of your cash outlay.

It is far better to go for the easy money by stepping over the one foot bars and be rewarded handsomely than stepping over ten foot bars and be punished for it.

With regard to taking profit, it is absolutely imperative to understand that it is okay to leave some money on the table as long as this money is at the near top of the total move in a stock price. The reason being is that you are leaving it for someone else to take the last bit of profit for taking higher risk.

That person who pays a higher price for the last bit of profit has a higher probability of losing it all.

  • Amen! Well said! I’m currently finishing Security Analysis by Dodd and Graham and despite I knew a lot about their philosophy of investing (after reading Intelligent Investor) I really understood the strength of value investing when it comes to uncertainty and risk. On my website I wrote a post (http://charlesmartineau.com/?p=642) on the weaknesses of the CFA exams where I questioned the premise of why does risk and uncertainty needs to be quantified and taught in the CFA when Graham (A founder if we can say of the CFA) would be totally against this idea!
    Anyhow-great post!

  • I struggle with this argument between risk and uncertainity – every single time.

    My argument goes something like this – We cannot measure uncertainity. But can we atleast try to measure an approximation of uncertainity in the form of some risk measure. Now, I am not hinting that beta is a risk measure (far from it – that would be just crazy), but say if we have a measure which says the possibility of losing x% of capital on this say, stock if event y happens – this variable is not a measure of uncertainity with 100% certainity (ha!), but close to it.

    Of course, the question is, do we have such a measure (I know VaR is not a fool proof concept, but does it approximate it?)

    What do you think?

  • I have been following stocks under five dollars for many years. I am genuine value investor. I am still amazed how easily investors will panic over things that are not that important. I guess you could say the reason so many investors are not successful in the market place is because they have never learned to live with uncertainity when it comes to investing.

  • @ Kiran,
    Thankfully, it’s the risk and uncertainty that produces opportunity.
    The problem with beta and any tests related to risk and uncertainty is that like you mentioned, none of it is certain.
    If you can actually quantify risk, then no risk exists since you know everything there is.. quite a contradiction lol.

    @James,
    Yup. I’ve found that uncertainty usually relates to short term events. Nothing major. It’s the uncertainty that has always produced golden opportunities.

  • somrh

    “In the stock market, there are always two sides of the trade, one side will be right and the other will be wrong. There is always a reason why the seller on the other side of the trade is selling to the buyer. Both will assess risk to the investment differently so this means one will be right.”

    I don’t see why this has to be the case. Consider the following example for illustrative purposes:

    Suppose that John owns Asset 1 and Sally owns Asset 2:

    Asset 1: US Govt bond with current price of $100. It’s price in one year will be a payment of $105.

    Asset 2: US Govt bond with current price of $100. It’s future price in one year will be $110 (50% chance) or $101 (50% chance).

    Further assume that this information is 100% correct, that Sally and John both know this information and there is no additional information that either could uncover that would tell them which of the outcomes (Asset 2 gets $110 or $101) will occur.

    Asset 2 is riskier than Asset 1, however, Asset 2 has a higher expected value ($105.50 versus $105).

    I contend that John could trade his Asset 1 for Sally’s Asset 2 and neither of them are “wrong”. This transaction might occur because Sally is more risk adverse than John and would rather accept a lower expected value for lower risk. John, being less risk adverse, is willing to take on additional risk for a higher expected value.

    I would argue that both are “correct” in that they both correctly understand the risk/reward structure for each asset. The only difference is that the two parties have a different risk aversion.

  • John

    Risk is not lowered if you have all the info on the stock, because the stock is still in the market and the market as many views.

    Risk can only be controlled through proper money management and position sizing relevant to your equity.

    Buffett would make large bets because after his early net net days, he buy the whole or majority of the company therefore cash flows, flow to his company alone.

    Graham bought net nets 50-100 at a time, they were so cheap and he was one if not the only guy in the store at the time.

    If you don’t practice money management and position sizing you could pick the most under valued or best stocks and still lose.

  • I’m pretty much in agreement with this article, in fact it mirrors my own thoughts on risk as presented in the article I wrote a little while ago. I’ll post the link to this article since some people will probably be interested in reading it:

    http://evanbleker.com/thoughts-on-risk/

    One thing I do not agree with in the above article is this:

    “In the stock market, there are always two sides of the trade, one side will be right and the other will be wrong. There is always a reason why the seller on the other side of the trade is selling to the buyer. Both will assess risk to the investment differently so this means one will be right.

    When a transaction takes place from a seller to the buyer, in effect, the seller is transferring risk to the buyer based on their own criteria of risk.

    In other words, the seller is really thinking that “I cannot manage the risk anymore so I am transferring it to the buyer who thinks they can manage the risk better in this investment”. It is up to buyer to decide with their own sound reasoning and judgment that the risk can be managed to a profit.”

    Its just not true that there is a winner and loser to every trade. This is an investing myth. There is a difference in the forgone return/loss and “winning” by selling/buying the stock based on the believed future direction of that stock. Every person who sells a stock that later rises forgoes that added profit just as the buyer of a rising stock gains profit through the purchase. The converse is true of stocks that fall in price. This is not the same as winning, though. You only win when you buy or sell a stock based on the believe that there will be some change in the direction of the stock. If you buy or sell for other reasons the direction of the stock is not always particularly relevant.

    People don’t always sell or buy based on the belief that the stock will go up or down. There are lots of reasons for selling a stock. One of those reasons is selling out to buy a car or pay for your kid’s university tuition. In this case the direction of the stock might not be relevant to the sale… and this likelihood increases when he sells out his entire portfolio. The person is simply not taking the bet that the stock will rise or fall, they just need the money now. Another counter example is when a person sells a stock to purchase a different stock that he feels is a better buy. In this case the investor can sell a stock that he believes will be decently profitable in order to buy another stock that he believes will be more profitable. In this case the person is not betting that the stock will go down – both parties agree that the stock will go up – so the seller is not taking that bet.

    You could say that the buyer loses because he’s electing to buy a stock that will under-perform the stock that the seller will soon buy but this is not the same as saying that there is a winner and loser to every stock sale based on the bet that the stock in question will go up/down.

  • Hey, why was my comment deleted? I’ll repost but take out the link if that was the problem.

    I’m pretty much in agreement with this article, in fact it mirrors my own thoughts on risk as presented in the article I wrote a little while ago.

    One thing I do not agree with in the above article is this:

    “In the stock market, there are always two sides of the trade, one side will be right and the other will be wrong. There is always a reason why the seller on the other side of the trade is selling to the buyer. Both will assess risk to the investment differently so this means one will be right.

    When a transaction takes place from a seller to the buyer, in effect, the seller is transferring risk to the buyer based on their own criteria of risk.

    In other words, the seller is really thinking that “I cannot manage the risk anymore so I am transferring it to the buyer who thinks they can manage the risk better in this investment”. It is up to buyer to decide with their own sound reasoning and judgment that the risk can be managed to a profit.”

    Its just not true that there is a winner and loser to every trade. This is an investing myth. There is a difference in the forgone return/loss and “winning” by selling/buying the stock based on the believed future direction of that stock. Every person who sells a stock that later rises forgoes that added profit just as the buyer of a rising stock gains profit through the purchase. The converse is true of stocks that fall in price. This is not the same as winning, though. You only win when you buy or sell a stock based on the believe that there will be some change in the direction of the stock. If you buy or sell for other reasons the direction of the stock is not always particularly relevant.

    People don’t always sell or buy based on the belief that the stock will go up or down. There are lots of reasons for selling a stock. One of those reasons is selling out to buy a car or pay for your kid’s university tuition. In this case the direction of the stock might not be relevant to the sale… and this likelihood increases when he sells out his entire portfolio. The person is simply not taking the bet that the stock will rise or fall, they just need the money now. Another counter example is when a person sells a stock to purchase a different stock that he feels is a better buy. In this case the investor can sell a stock that he believes will be decently profitable in order to buy another stock that he believes will be more profitable. In this case the person is not betting that the stock will go down – both parties agree that the stock will go up – so the seller is not taking that bet.

    You could say that the buyer loses because he’s electing to buy a stock that will under-perform the stock that the seller will soon buy but this is not the same as saying that there is a winner and loser to every stock sale based on the bet that the stock in question will go up/down.

  • Whoops, my bad. 🙂

  • RobS

    A good post. I’ve been puzzling over the concept of risk for a week solid now as I’ve been going through Aswath Damodaran’s course on valuation. His method for calculating a companies cost of capital is heavily weighted towards the market’s view of the riskiness of the investment. What do people here think of his use of a “bottom-up beta”? The idea is that one should look at the average beta for all other firms in that industry, and scale this to account for how leveraged the current firm is. My problem with his method(s) are that you are incorporating the market’s views into the valuation – which surely turns it into a pricing model no?

    I can however see how his method could be useful in determining whether a firm is earning it’s cost of capital – perhaps more useful for shorting? I object mostly to using market inputs (implied risk premium of equity and beta) in the discount rate to determine a so-called intrinsic value.

    To add to what Evan said above, consider that different market participants are also operating on different time lines. Take any stock. Look at the intraday price movements. Zoom out a level to the daily price movements over the last 6 months. Zoom further out to weekly price movements over the last 18 months. Zoom out again to monthly prices over the last 10 years. If you removed the axis labels from each of these graphs and shuffled them up, I wager you’d have trouble telling the difference (07-08 crash would stick out a bit however). This is what you see in fractal systems – within the set, your local environment can look identical at different points, and at different scales. The Mandelbrot Set is the best visual demonstration of this.

    So while we might think in the long term only one side of the trade is correct, measured over different time scales the answer can change.

    That said, always question why that other person is willing to sell to you – do they know more than you? That’s where you have to weigh up the uncertainties IMO. I like Montier’s suggetion for a reverse-DCF here – or sensitivity analysis as demonstrated by the ever insightful R Crawford in the recent past.

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