Thoughts on risk

I was 12 and the hill looked enormous.  I'd done it in the past with success, so much success that I could almost taste the thrill.  The thrill of riding a bike down a steep hill on a rutty dirt path and then flying through the woods.  The sense of completion from doing something dangerous, and the sensation of my stomach in my throat.  I went first and my friends watched.  Everything started well until my front tire hit a root.  Suddenly I was going faster than my bike, except I forgot to let go of the handlebars.  My bike and I were flying through the air before we finally landed in a jumbled mess on the ground.  The landing left a mark, a scar that took years to fade away.  My friends rode down without issue, they enjoyed the thrill.  At 12 I didn't want to look like a wuss, so I got on my bike and slowly followed through the woods.


The hill wasn't any bigger than it had been in the past, and others navigated it with ease on the day I crashed.  Risk is unfair.  That hill was too risky and I knew it, but I was too young and dumb at the time to not ride.  I took a risk and felt the literal pain of that decision for weeks.  Just because my friends made it down the hill without incident didn't mean the risk was nonexistent.  It just hadn't shown up yet.

The markets are full of risk.  Some might even content that the only thing that matters is risk.  Investors who are riskier earn more, investors who earn less took less risk.  Risk is the storyline academics use to explain market movements.

One thing markets do incredibly well is hide risk.  Millions of investors might buy and sell a company without issue before the company suddenly announces their largest product failed.  If you're the unlucky investor sitting in those shares on that day risk appears in a large way you could face a significant loss.  What was a safe company is suddenly risky with investors running to the exits.  Questions about the company's viability begin to appear.  Investors question themselves on whether they want to continue to hold.

I'm convinced that humans are terrible at assessing risk.  True risk, not the statistical likelihood of failure.  If there is a large enough sample size we can estimate failure.  But even then failure doesn't always happen the same way.  And an exogenous event might increase the failure rate in a way we never understood.

Many investors pride themselves on their ability to predict the future.  I read the recent interview with Stanley Druckenmiller and he calls this one of his greatest assets.  The ability to see a future event clearly and bet the farm on it.  If one has that ability, and judging by his returns he seems to, it would be foolish to not bet the farm.  But not only your farm, the neighbor's farm, the farms of relatives and anyone else's capital you can get a hold of.

I'm terrible at predicting the future.  I can do alright with softball predictions like "more people will use phones in the future compared to now."  But those aren't actionable insights.  Some macro trends are very predictable but impossible to act on.  Like the high school football player trumpeting their success 30 years later I have one prediction I made in college that was 100% spot-on.  I predicted in 2001 that in 10-15 years the internet will fill the air and we'd be able to connect everywhere.  I had imagined some sort of wifi system, but it was the phone system that filled the gap.  I was right, but there was no way to capitalize on it.  Most of the wireless companies at the time are gone now, and the technology has dramatically changed.

While I'm not good at predicting the future I am good at one thing; determining the worst case scenario.  I have a wild imagination and it's not too hard for me to start thinking about driving somewhere for a vacation and end up imagining a collapse of civilization and me sleeping in a tent on the side of the road.

I prefer to view risk in terms of the worst case scenario for a company.  Obviously the survivalist societal breakdown storyline might be entertaining, but it's not a true worst case for investors.  If we are reduced to drinking from streams and eating berries I don't think we'll care much about stocks.

For some companies a worst case scenario is a loss of confidence by their customers.  Business isn't build on the premise of the highest quality item for the lowest price.  It's built on relationships.  A company might work with a higher cost supplier because they like the sales rep, or the supplier is more flexible with some aspect of their process.  Another worse case for a company could be the loss of a critical supplier.  A piece so critical that without it production ceases.

Every business has one or more critical failure points.  Some companies need water, others types of metal, some reliable servers.  The list is endless.

Assessing risk means looking at the worst case scenario and then determining the likelihood that the company can overcome that issue.  If a brewery loses their water supply they can't make beer.  But do they have enough cash that they can pay to have it trucked in for a period?  If they are living paycheck to paycheck the loss of water for a week due to a water main break could be the difference between making interest payments and missing an interest payment.

The riskiest investments are ones where if the worst case scenario were to take place the company could end up in bankruptcy court or in liquidation.  A loss of a critical supplier when no replacement is available, or the loss of consumer confidence due to a fatal error can cripple a company forever.

Companies have the ability to rebound from a variety of problems.  When I was looking at Japanese net-nets there were companies that could last for 20-30 years without another cent of revenue.  Outside of a Japanese Yen devaluation or outright fraud those companies were almost risk-proof.

When looking at risk from a portfolio perspective it's important to dig into the worst case scenario of each holding.  But a potential danger for investors is that they will become too pessimistic and never invest in anything.  I temper my worst case evaluation with my optimistic belief that humans are creative, inventive and resourceful, and when put in a tough situation usually find a way to get out with the least pain.

When considering a new investment I like to think about potential worst case scenarios and their implications for the stock.  Am I comfortable with the downside in each of those scenarios?  If I am and the stock is undervalued then it's very likely I'll buy a position.  Is my risk analysis as precise as mathematical models?  Absolutely not, but I also believe it captures a lot of situations models fail to catch too.  One of the keys to making money in small undervalued stocks is avoiding losses.  While my risk assessment methods might be unorthodox they do seem to work with avoiding losses.

 

Fantastic read! Very well said and well-explained of article you have posted here. I love your amazing ideas and great tips here. I will surely try to use some of it! Keep posting! :)

 

Great post. What I will say is that risk isn't just about the worst case scenario, but how likely that scenario is. Google could get nuked tomorrow, but I'm not gonna decide to not invest in it based on that because the chances of that happening are infinitesimally small.

"There's nothing you can do if you're too scared to try." - Nickel Creek
 

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