Philip Fisher wisely said, ‘‘The greatest investment risks are the ones you take without knowing what you’re doing.’’
This wisdom underscores the essence of intelligent risk-taking in the investment world.
While we have several financial metrics to gauge risk, let’s face it – they all fall short of capturing the full spectrum. But they’re all we’ve got.
Consider this: when you buy an extraordinary business, run by excellent management with significant skin in the company, what do you think is more likely to go wrong?
Mark Twain, in his wisdom, articulated, ”It ain’t what we do not know that gets us in trouble. It’s what we know for sure that just ain’t so.”
Howard Marks was once asked by a reporter, “How can you buy high-yield bonds when you know some of the issuers are going to default?”
His response was thought-provoking: “How can life insurance companies insure people’s lives when they know they’re all going to die?”
It all boils down to smart, calculated risk-taking.
As Albert Einstein eloquently put it, ‘’Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.
This insight applies to the world of investment as well.
Not everything that can be calculated holds equal importance and some calculations are vulnerable due to inherent weaknesses and assumptions, especially during times of significant market uncertainty.
Take, for instance, one of the primary measures of investment risk — volatility.
Volatility calculations rely on historical data, but when we invest, we’re essentially investing in the future.
Assuming past performance will repeat itself often leads to disappointment.
However, if you select an outstanding business that ticks all the criteria you are increasing the probability of getting a few right and that’s all you need.
In our view, volatility isn’t the real risk; the genuine concern is the possibility of a permanent capital loss.
For example, short-term market fluctuations can unsettle investors but recovery is more probable if investors have a long-term horizon.
Of course, that implies you are invested in a great business.
It’s hard to predict the future because we haven’t experienced it yet, but we can estimate the likelihood of risks based on what we know and what we can analyse.
Safeguarding your investments involves diversifying across sectors, countries, industries, and currencies and investing in management with impeccable integrity.
By increasing your diversification among uncorrelated assets you are reducing your risk significantly.
Those who are not comfortable with market volatility are more likely to invest in low-volatility assets, but often, this path is more likely to result in mediocre returns.
In a study from 1926 to 2019, on average, a 100% investment in a bond portfolio generated 5.3% a year, while a 100% investment in stocks generated 10.3% a year.
It is important to protect your downside while leaving a margin of safety for the unknown.
As Ben Graham said, if you buy an asset worth £1 for 50 pence, if you are wrong you have protected your downside for margin of error.
Mastering risk is the key to exceptional investment returns.Here are the questions we ask ourselves regarding risk:
- What is the probability that the business will regain its earnings power in the next 5 years?
- Is the business financially well equipped to withstand storms internally without raising capital from the market?
- How much can we make if things go well?
- What’s the probability of the company being liquidated, and how would shareholders fare — loss, break-even, or profit?
- What are the most significant risks, threats, or hurdles the business may encounter?
- How much could we potentially lose if things turn for the worse?
- How bad would things have to get to prevent the company from arriving at the destination imagined?
- If I had to invest in a few companies, would the business be one of them?
- How can we be sure that we are making the right decision? What if the alternative would bring better results?
The answer is that we cannot be certain about everything since the future has not happened yet, but we only make the best decision based on the information available at the time.
You have to be comfortable with the world being an uncertain and unpredictable place. As Seneca said, ‘’Time will discover truth’’ if we are right, great if not we learn from it and keep evolving.
Awet Ghirmay, Head of Investment Research
If you want to learn more about this topic, please find the link here.
More information about our fund can be found here: Hargreaves Lansdown or AJ Bell
Risk warnings
The value of investments and the income derived from them may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs practice. Levels and bases of tax relief are subject to change. This blog is based on my own observations and opinions.
