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Investment Risk

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By Robert Leost

Robert Loest, Ph.D., CFA

Too often investors in difficult markets fail to distinguish between price volatility vs. investment risk. If you are in stocks and the market tanks, so will you. It doesn’t matter if you own the best managed, most undervalued companies this side of Pluto. You may tank less than the market, but you will tank. Let’s explore this a little more deeply, though.

Peter L. Bernstein describes a letter Albert Einstein wrote to his colleague, the famous physicist Max Born, in which he said to Born: “You believe in a God who plays dice with the universe, and I believe in a God with complete law and order in a world that objectively exists.” Peter Bernstein’s book, Against the Gods: The Remarkable Story of Risk, is the best book on investment risk ever written. He’s probably the most revered living investment advisor, and it’s a fascinating read. It isn’t about statistics at all.

Bernstein hoped Einstein had it right. “If law and order do not govern how nature works, then we are living in chaos, and science is nothing but mumbo jumbo.” But either we don’t know all the laws, or they don’t always work (or both). There is no such thing as an R2 (correlation with the stock market) of 1.0. We live in a world where complete law and order do not objectively exist, and where we don’t know the future. We live in a world where the only common sense approach with stocks at any time is to be conservative.

Price volatility is not the same thing as investment risk, though. Confusing the two is fatal for investors. If you buy a great, undervalued blue chip stock with a 5% dividend yield covered 5 times over by free cash flow at half of estimated fair value based on a really conservative methodology like discounted free cash flows, it’s probably a huge investment bargain, but the stock price will still go up and down on a daily basis, sometimes by a lot. If that scares investors, they have no business investing in stocks, period.

Risk in the stock market is widely viewed by professional investors as boiling down to three kinds of risk:

• Company risk
• Market risk
• Currency risk

I disagree. I boil risk down to one category: Mean Reversion risk. I like Elroy Dimson’s definition of risk: More things can happen than will happen. It’s a profound, thoughtful definition, as Peter L. Bernstein points out. I can only measure the risk that I know, but there are risks I do not know, and measurements I make that will turn out to be wrong. How do I minimize the consequences? By building in Benjamin’s famous “margin of safety.” It doesn’t protect us from daily or monthly price volatility, nothing does, but over reasonable investment horizons of a year or more, it does tend to minimize the negative, and inevitable, effects of the risks I do not know about, and the measurements & assumptions I make that are wrong.

All markets, publicly traded assets and derivatives obey the statistical iron law of mean reversion. Prices fluctuate around (above and below) some central tendency, or measure, of fair value (long term average P/Es, P/Bs, discounted cash flow estimates of fair value, etc.). The mean is simply the estimate of fair value, based on whatever metric you are using.

If stocks trade above fair value, however you measure it, they will eventually mean revert downward. If they trade below, they will eventually mean revert upward. A portfolio full of such stocks will mean revert (either up or down) regardless of company, market, or currency risk, over periods of a year or longer. But not necessarily day to day.

If you overpay for stocks, your portfolio is exposed to downward mean reversion. If you underpay, it’s exposed to upward mean reversion. Think about it. If you consistently underpay by a large enough margin, you don’t need to worry about whether or not your company comes out with a blockbuster new product, a merger or acquisition, meets EPS and growth targets, or experiences other good news. You are no longer exposed to the whims of the gods, you are relying on the iron law of mean reversion to make your money, nothing else!

Mean reversion risk tends to trump all other kinds of risk. This is why I recommend such a conservative measure of fair value. Discounting free cash flows, and buying only at a large discount to that estimate of fair value, is as conservative as you can get. It minimizes the risk of downward mean reversion. It doesn’t eliminate it – prices are volatile, as we’ve seen recently. People make mistakes, including me, and unexpected or unpredictable events will affect the market unpredictably. Stuff happens.

Peter L. Bernstein wrote recently that “To me, risk management is not about measurement at all. It is about how we make decisions and only incidentally about the math we use in making those decisions.” Risk management is not about managing a number, it’s about the investment methodology that produces those risk numbers. The numbers are simply a monitoring device. This is why understanding the methodology your manager uses is so important. Inherently conservative methodologies should produce lower risk, but studies have shown that they do not necessarily produce lower returns. Some studies, in fact, show the opposite, despite the widely believed investment myth that return if proportional to risk. Studies over the years of actual portfolio behavior simply do not support that belief.

Investors goal should not be a high raw numbers return, but a high risk-adjusted return. Investors should worry a lot more about investment risk, and a lot less about price volatility risk. It isn’t price volatility that keeps me awake at night, it’s investment risk, and I value my sleep.

Robert
Robert A. Loest, Ph.D., CFA

More Stock talk by Dr. Loest