ValuePickr Forum

TMIT Chapter 6: Recognising Risk

Recognising risk often starts with understanding when investors are paying it too little heed, being too optimistic and paying too much for a given asset as a result. High risk, in other words, comes primarily with high prices.

Controlling Risk in my investments - has been a concern, since 2014. HM says great investing requires both generating returns and controlling risk. And recognising risk is an absolute prerequisite for controlling it.

Whereas the theorist thinks return and risk are two separate things, albeit correlated, the value investor thinks of high risk and low prospective return as nothing but two sides of the same coin, both stemming primarily from high prices.

HM asks us to recognise that just like opportunities to make money, the degree of risk present in a market derives from the behaviour of the participants, not from securities, strategies and institutions.

Every active investor in markets goes through this, sooner than later

“It is what it is. We’ve been living in optimistic times. The cycle has been swinging strongly upward. Prices are elevated and risk premiums are slender. Trust has replaced skepticism, and eagerness has replaced reticence. Do you agree or disagree? That’s the key question. Answer it first, and the implications for investing become clear.

He elaborates some more with

“Everything you needed to know in the years leading up to the crash could be discerned through awareness of what was going on in the present.”

So, there is very clearly a “Call to Action” from HM when we see those un-ignorable signs of danger. Yet very rarely do we see any prominent Value-Investors advocating taking money off the table (progressively, if you will) as a means of Controlling Risk, when these danger signs are all evident!

In fact, the opposite is probably advocated by Value Investors - Stay put in Quality stocks and sit through the boom and bust. Whereas HM is clearly saying,

No risk is feared, and thus no reward for risk bearing— no “risk premium”— is demanded or provided. That can make the thing that’s most esteemed the riskiest. Perversity of Risk. This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky.

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So the question for me:

HM says “A few times in my career, I’ve seen the rise of a belief that risk has been banished, cycles won’t occur any longer, or the laws of economics have been suspended. The experienced, risk-conscious investor takes this as a sign of great danger.”

HM elaborates further, on course of action. “It is what it is. We’ve been living in optimistic times. The cycle has been swinging strongly upward. Prices are elevated and risk premiums are slender. Trust has replaced skepticism, and eagerness has replaced reticence. Do you agree or disagree? That’s the key question. Answer it first, and the implications for investing become clear.”

HM emphasises some more on this. “Everything you needed to know in the years leading up to the crash could be discerned through awareness of what was going on in the present.”

This seems like very clear suggestions that it’s quite possible for the diligent investor to recognise Market bubble conditions, if we can be aware. And definitive “Call to Action” when we recognise such times. Isn’t he suggesting taking money of the table at such times - unlike what typical Value Investors advocate, and warn us against trying to time-the-market? That it’s almost impossible for normal (even skilful) investors to achieve?

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Now to the more promising part, on HM’s take as a Risk-Taker demanding Risk-Compensation while investing

“I wouldn’t buy that at any price— everyone knows it’s too risky.” That’s something I’ve heard a lot in my life, and it has given rise to the best investment opportunities I’ve participated in. … The truth is, the herd is wrong about risk at least as often as it is about return. A broad consensus that something’s too hot to handle is almost always wrong. Usually it’s the opposite that’s true."

And HM further elaborates

“When everyone believes something is risky, their unwillingness to buy usually reduces its price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing, since all optimism has been driven out of its price.”

I am trying to pay special attention to this, these days. Can’t we be even more picky for situations where - Fundamental Quality is unquestionable, and say ditto for Management Quality - meets a transitory “Risky” situation - that is bound to boil over (with attendant lower trajectory results) in 4-8 quarters, say? Isn’t that when WB advocates (having the courage of hitting the hardest) and demonstrated time and again with huge bets such as on Coke, Amex or others?

Can’t we all learn to apply that well - keep our eyes and ears open - antenna perked?

  • what about a Divi’s Labs?
  • what about a Jubilant Foods?

Disc: Business Names taken only as food-for-thought examples, to drive home the message. Not advocated as investment ideas. These may prove be (very) Risky Investments.

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