Parental approach to investment risk

Risks we entirely avoid vs risks we cautiously manage

“We need someone genetically programmed to recognize and avoid serious risks, including those never before encountered.” – Warren Buffett, on what looks for in his successor

What’s the most important thing in investing? The most misunderstood thing? One-word answer to both questions is “Risk”.

The most important thing

Risk-return is correctly hyphenated, but finance academics make a mess of the hyphen. They err on both correlation and causality. They always see a positive correlation. High risk, high return and vice versa. They obfuscate on causality. Risk and return are generic X-Y coordinates for plotting curves with fancy names like ‘efficient frontier’. Finance professionals wrongly obsess on returns over risk. That’s equivalent to watching the scoreboard instead of watching the ball.

In reality, the ONLY parameter an investor controls is risk. Everything I do pertains to risk. Starting with the risk that I don’t know what I’m doing. If I clear this, I get to other risks. Bad people. Tough neighborhood. Distractions. Steady erosion. My getting carried away. Or worse, losing my nerve. If I manage all these risks competently, I end up with a wonderful business run by trustworthy people bought at a fair price. This low-risk construct causes returns to follow. More precisely, odds become favorable. And herein lies the correct relationship. Done right, there is no trade-off. The job of an investment professional is to make low-risk and high-return go hand-in-hand.

The most misunderstood thing

Bizarro World, a fictional place where everything is opposite, is a DC Comics creation. It’s a cube-shaped planet where heroes are villains, beauty is ugliness and stupid is smart. Imagine my surprise when I found this world in the non-fiction section, while studying finance and economics. Bizarro humans are perfectly rational, fully informed and maximize an unknowable thing called utility. This leads to Bizarro ideas such as CAPM and EMH. The piece de resistance of Bizarro World is undoubtedly Bizarro risk, which also goes by names such as sigma or beta. Imagine a finance professional at home, thinking of risk as bad things happening, like a normal person does. As he reaches his Bloomberg terminal in office, he magically steps through a portal into Bizarro World. Here, Bizarro risk is unrelated to:

·      Harm: risk isn’t about losing money but about how squiggly a line on the screen is

·      Reality: risk has nothing to do with the business one owns but exists by itself in the ether

·      Complexity: risk isn’t an assessment but a precise number

·      Science: risk isn’t about empirical validity but about clinging to a theory first debunked in ‘92

·      Language: risk isn’t English but Greek

This treatment of risk is the most damaging case of physics envy that I know of. Despite Beta being empirically invalid for decades, finance people still cling to it. Otherwise, an entire edifice would collapse. There wouldn’t be a precisely flawed cost of capital to rationalize silly M&A. No models. No oversimplified ratios to tout. No papers to publish. No tenure. Such blatant mishandling of risk reminds me of Bertrand Russell’s quote “Most people would rather die than think ; many do”.

A (way) better approach to risk

Becoming a parent changes everything. One especially big change is on how I think about risk. It’s unnerving to be responsible for the safety of a stochastic, fast, little creature with warped notions of fun and danger. I, like most parents, think about it at two levels:

·      Deep end? No way. Baby pool? With floats.

·      Cycle on main road? No way. Cycle inside compound? Slowly.

·      Roadside chaat? No way. Chaat at birthday party? Try some.

·      Stunts on top of bookshelf? No way. Stunts at ground level? Away from hard objects.

·      More generally: Big harm? No way. Small harm? Manage carefully.

While we’re extra paranoid in childcare, we use this two-level approach across the board. In health. While driving. When travelling through a new country. This sensible, parental approach works just fine in investing as well. The central tenet is to distinguish between risks that you entirely avoid and risks that you assume (at a price). The former essentially involve ruin. Then, act in line with this distinction. First, avoid ruin. Second, cautiously manage everything else.

What’s ruin in investing? Losing most of my money. What kinds of things cause ruin? Stuff I can’t figure out. People I cannot trust. Places where no one makes money. Neighborhoods where they steal your money (e.g. real estate). Where my interests aren’t aligned with the promoter’s. Where things are changing too fast. Where future wholly depends on kindness of strangers. If I spot ruinous risks, I don’t analyse further. I’m done. Ruinous risks are to be avoided, not priced. When ruin is in the picture, “buy at no price”.

Investment is about judgment and temperament. The latter is way harder. Many investors have the judgment to spot ruinous risk. Most falter on the temperament to then do the right thing: walk away;  dismiss it from the mind; don’t engage on lesser risks; don’t get tempted. Let’s take the illustrations from my previous essay. With demonstrable evidence of hanky-panky, the right investment thesis is “Promoter is a crook. The end.”. However, most investors end up with “Promoter is a crook, but …”. But, he’s hired a well-credentialed CEO. But, industry’s so exciting. But, stock is so cheap. But, he did mother-promise that he’ll not screw minority shareholders again. Trying to price an unpriceable risk rarely ends well.

If (and only if) there aren’t any existential risks, I get to incremental risks. These are manageable, albeit thoughtfully. These include the likes of industry, competition, moat, threats and capital allocation. I assess each qualitatively, looking to clear a ‘good enough’ bar. Then, all things considered, I have a holistic view of business risk. That guides me on how I manage valuation risk. When ruin is not in the picture, “buy at a price that factors in non-ruinous risks”.

If I don’t screw up along the way, both risk and returns line up. I have reasonable odds of a good return, good odds of a reasonable return and minimal odds of a ruinous return. Bizarro World be damned. 

[Originally published in Dec-2019 at https://www.linkedin.com/pulse/parental-approach-investment-risk-anand-sridharan/]