For me the most important chapters in HM’s TMIT are on Understanding Risk, Recognising when Risk is High (Ch 6), and Controlling Risk (Ch 7).
Everyone interested in subject will obviously do a through read of the Chapter. So, I want to tackle the subject a bit differently - by bringing out my reactions - as I read and re-read his profound tackling of the subject. What has stood out so far
HM said
“I’m sure “risk” is— first and foremost— the likelihood of losing money. The possibility of permanent loss is the risk I worry about, Oaktree worries about and every practical investor I know worries about”
HM also says
“Skillful investors can get a sense of risk present in a given situation. They make judgment primarily based on (a) the stability and dependability of value and (b) the relationship between price and value. Other things will enter into their thoughts, but most will be subsumed under these two”
And then, most revealingly
“Looked at prospectively, much of risk is subjective, hidden and unquantifiable. I realized that because of its latent, non-quantitative and subjective nature, the risk of an investment – defined as the likelihood of loss- can’t be measured in retrospect any more than it can a priori.”**
I find it useful to think about the 3 significant aspects of understanding Risk, in this way
1. Informed Judgement call on Stability and Dependability of “Value”
in other words the stability and dependability of future cash flows - what does it depend on?
To my mind that depends entirely on the stability and dependability of the Industry and the firm’s competitive strategy/position within it
I think it is quite possible for non-consensus investors (who work hard and have familiarity with a business/industry over 3+ years) to establish if the competitive strategy/position of that business has become stronger or weaker - and make an informed judgement call on the stability and dependability of competitive position, and thus value
2. Risk is only about Permanent Loss of Capital
Again if it were possible for us to focus on that singular aspect of continued strengthening of
competitive strategy/position of a business (or the visible diminishing of it), we would have a much better shot at avoiding any permanent loss of capital (and even Opportunity)
3. Risk can’t be measured in retrospect any more than it can a priori
The fact that we can’t know even for a successful investment held over 6 years, whether the Risk-Adjusted return was high or not (just because it didn’t happen, doesn’t mean risks leading to capital loss were unlikely) is the most astounding aspect of “risk thinking” for me
But again a practical course would be to make that judgement call on whether the industry/business competitive position has strengthened in those 6 years. If it has, there is every likelihood that Risk-Adjusted Returns were high.
{Nothing like a live, good example to illustrate For all the Avanti Feeds skeptics - that’s a good way we have found to convince ourselves (even as-on-date, that we are onto a good risk-adjusted returns story there, given that (we think) additionally there still exists a Gap between Price and Value}
Counter-Views invited, as I read and think more on subject.