Site icon UK Investor

Value Investing and the Concept of Risk

Risk, Investment risk

One of the primary factors that set value investors apart from the rest of Wall Street and City of London traders is their definition of risk.

City traders and investors tend to use quantitative factors such as value at risk (VaR) models to determine the risk exposure for their portfolios. VaR models use historical volatility data to estimate the probability losses, which is helpful for day traders, but not necessarily useful for long-term value investors.

Instead, value investing defines risk as the possibility of a permanent capital impairment.

What does this mean? It is the likelihood of a stock you own going to zero.

Here’s Warren Buffett explaining the difference between risk from a value investor’s perspective, and volatility:

“We define risk, using dictionary terms, as ‘the possibility of loss or injury.’ “Academics, however, like to define investment ‘risk’ differently, averring that it is the relative volatility of a stock or a portfolio of stocks — that is, their volatility as compared to that of a large universe of stocks. Employing databases and statistical skills, these academics compute with precision the ‘beta’ of a stock — its relative volatility in the past — and then build arcane investment and capital allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong. “For owners of a business — and that’s the way we think of shareholders — the academic’s definition of risk is far off the mark, so much so that it produces absurdities.”

Put simply, rather than trying to avoid volatility in your portfolio, you should seek to make sure you don’t end up losing money. If you focus on minimising risk, rather than maximizing reward, returns should follow.

“The best investors do not target return; they focus first on risk, and only then decide whether the projected return justifies taking each particular risk.” — Seth Klarman

Seth Klarman, one of the most successful investors of all time, who follows the value discipline, knows all too well how important it is to focus on risk above anything else. His firm, the Baupost hedge fund, has generated annualised returns for investors of more than 20% for the past two decades. Klarman has achieved this record with minimal risk. As he described in a letter to investors:

“For 25 years, my firm has strived not to lose money — successfully for 24 of those 25 years– and, by invest and cautiously and not losing, ample returns have been generated. Had we strived to generate high returns, I am certain that we would have allowed excessive risk into the portfolio– and with risk comes losses. Some investors target specific returns. A pension fund, for example, my target an 8% annual gain. But if the blend of asset classes under consideration fails to offer that expected result, they can only lower the goal– which foremost is a non-starter– or invest in something riskier than they would like.”

Klarman and Buffett describe the concept of risk and value investing better than I ever could. It’s difficult to understate just how important risk management is for value investors.

Exit mobile version