Understanding Risks, Bracing For Unexpected

Asymmetric risk perception - whenever we’ve higher stakes, fear takes over. We tend to extrapolate the current perceptions despite knowing the future probabilities range much wider

When discussing equities, most people immediately think of risk and, of course, returns. Returns are often framed in terms of multi-baggers (e.g., "x times" growth) or percentage gains. However, when it comes to risk, the focus usually shifts to potential losses - whether measured in percentage declines or the complete erosion of the initial capital. Another commonly misunderstood concept is volatility, which is frequently conflated with risk, even though many quantitative metrics are built around it. While various methods exist to quantify risk, none are entirely precise or perfect. That said, grasping the true nature of risk is essential for making well-informed investment decisions.

Risk in a way could be construed as something that’s not certain in an outcome. Risk is when there’re more than one potential outcomes with likeliness of their own eventuality. This probabilistic nature places away from our likened or expected outcome. In this regard, I like the example of Howard marks story of a gambler who lost regularly. One day he hears about a race with only one horse in it, so he bet the rent money. Halfway around the track, the horse jumped over the fence and ran away.

So, is the mere possibility of the outcomes defines the risk or are the consequences of the outcome that define risk. For instance, if the gambler has invested his money versus the rent or borrowed money. The gambler might lose all his own money but if he’s levered then he retains a debt burden in case of a loss. Thus, if the consequences are negligible, uncertainty alone doesn’t make something ‘risky’.

This is where Morgan Housel’s definition of risk paves for a credible understanding. He puts it as three sides of risk.

l The odds you will get hit (how likely is a negative outcome)

l The average consequences of getting hit (what’s the typical damage)

l The tail-end consequences of getting hit (how such a damage impacts one)

The first two are easy to grasp. The third is the hardest to learn and can only be learned through experience. We always know we’re taking chances when we bet or approach a risk but how that outcome impacts us or how we react to such situations is only learned through experience. That possibly can’t be simulated. Most equity investors are aware of tail-risks like dot-com bust, GFC, etc. but they’re often underestimated.

What I’ve learned in my experience is that risk tolerance of investors isn’t constant. It changes with the circumstances. Case in point, yesterday I was interacting with an investor who once loaded up on shares of a struggling IT company, betting on a turnaround. Years later, the stock soared, delivering huge profits. But now, amid sector-wide pessimism, he’s nervous - despite having previously embraced the risk.

The shift in behavior is because of:

Loss aversion - he holds the position now and protecting huge profits than chasing further upside.

Recency bias - recent news is fresh in mind and is more impactful than his own past success.

Asymmetric risk perception - whenever we’ve higher stakes, fear takes over. We tend to extrapolate the current perceptions despite knowing the future probabilities range much wider.

Similar proceedings happen during bubbles with only in reverse where negative outcomes are almost always suppressed in the probabilities, by the investors.

The only ways to counter risk is through diversification andtime.

Diversification - A well-structured portfolio reduces dependency on the outcome of any single asset or security. It should lump together least overlaps and/or least correlated securities/assets. The goal is to not completely avoid losses but achieve outcomes less deviant from the expectations. Of course, over-diversification could lead to diworsification as termed by Charlie Munger, does more bad than good for the portfolio.

The popular adage, time heals everything, could apply to volatility especially in equities. Equity investors (mostly in portfolios) benefit over extended periods while it could turn worse in a single stock,if the changes are fundamental and governance issues.

While diversification and time are the best defenses, neither is foolproof. Understanding risk isn’t about eliminating it but about making informed choices despite and preparing for the unexpected.

(The author is a partner at “Wealocity Analytics”, a SEBI registered Research Analyst firm and could be reached at [email protected])