Risk: It's More Than Just A Board Game

What is Risk?

This really is a simple 3 word question. However, the answer is somewhat suspect and really depends mostly on perception and what is happening in the world where the conversation is occurring. If we look at a few scenarios, we can start to develop a perception of risk. A boy says to his buddy “let’s jump off this 25 foot cliff into the lake below.” Most would argue there is some risk of getting hurt from a bad landing. The risk could be greater if the depth of the water is unknown and death creeps into the risk equation. However, if both are trained cliff jumpers, the depth of the water is known and the experience at the said jumping point is deep then the risk may be marginal. Indy car driver Juan Pablo Montoya sits atop the list of the current points race in the Indy Car Race Circuit. Getting into an Indy car presents some risks, death, injury, the possibility of hurting someone else, loss of sponsorship dollars due to a crash, fire, reputation, etc. Putting an unskilled driver in the seat of this Indy car increases the risk by a serious multiple. When we turn to the economy and the markets, risk becomes different but similar. When we look up risk on the internet we find the definition as suggestive of losing something of value, physical health, social status, emotional well-being, or financial wealth. Risk also gets expanded to include uncertainty and the perception of this uncertainty. When we get to this point, we start to hear from the mathematicians and quantitative analysts about the probability of events happening when uncertainty exists. Typically when we go down this road of assessment, we lose half the audience because of left and right brain biases. Given this, we will simplify the definition of risk as ‘the potential for loss.’ In our world, that seems to be all people really care about.

Consider a hedge fund that you give $1 to. The said manager takes that dollar and leverages it up to invest (buys) $2 of capital. Some would suggest this is risky. However the said manager is not that risky and takes another $1 of capital and shorts (sells) equities in the market. This gets us back to $1 of net exposure. While gross exposure is $3, remember we started with one dollar. Is this risky? If in a crazy world, the buys (longs) went down by 50 cents and the sells (shorts) went up by 50 cents then theory might suggest that there would be no capital left. The probability of this happing is remote and mathematically likely less than 1%, however this is reflective of the risks that are currently active in our markets. In the above example we could have said a bank versus a hedge fund, and in some respects the leverage at a bank is significantly higher.

Our simple definition of the risk of loss needs a bit more development. The clear or critical second question is: risk of loss over what time period? One day? One month? A quarter? A year? 3 years? Warren Buffett has suggested in the past that investment statements should be sent out once every 5 years.

Change Affects Risk

Below is an image that was at the leading edge of technology in 1996: The Motorola StarTAC Flip Phone. You could place mobile calls on this phone, and you could likely text too but no one knew how to do this back then. People got their stock quotes from the newspaper the next day typically, not mobile alerts minute to minute. This phone was not a camera. Was the risk higher or lower in 1996 because of delivery of information?

Was the risk of loss higher in 1996 because information was not as available as it was today? The answer is quantifiably yes and no, or it depends on timeline and perception. Right? If you were looking to make money on a one day trade and you did not have a StarTAC, the risk would have been high. Perhaps in the short term, regardless of information flow, the risk of loss is always higher.

Real World

Is there risk in owning Coke? It depends on your objective, one could surmise. Coke is arguably a great company and has been around since 1944. The brand is iconic and it can be seen in almost every part of the world. The image below is from Mongolia where, clearly, they drink Coke too.

But is there risk in owning Coke? It really depends. How about opportunity risk? This is a different risk all together. For simplicity sake, imagine owning one dollar worth of Coke over the last 40 years. That dollar of Coke is now worth $40. Pretty good. However, had you owned Proctor and Gamble, your dollar is worth $80, or had you owned IBM that dollar is worth $168 today. Interestingly, at no point has the investment in any of these companies been a smooth ride higher. There has always been the risk of loss over certain time periods.

Maybe the answer or question of risk is: what risk is right for you? Arguably, everyone in the survey would rather have $1 go to $160 dollars, but at what cost? 9 years of disappointment from 2000 to 2009? Or the lost 14 years from 1980 to 1994? Or maybe Coke is the real thing! Depends, I guess, on who you are talking to.

Here is a fun little video on risk. It is very simplified, but helps explain the basic concept:

http://www.investopedia.com/terms/r/risk.asp

Wrap Up

Risk is ultimately different things to different people at different times and in different circumstances. Today, the risk might be what am I missing? Tomorrow, the risk might be what did I miss? We view our position as understanding this for all, and looking to provide guidance and advice to manage through periods where there is uncertainty. We remember 2008, and constantly remind ourselves that the joy of a gain is far less than the pain from a loss.

 

Sources:

Wikipedia – Definition of Risk

Motorola 1996 Image of StarTAC

Dumell.net – Mongolia Image

Wikipedia – Coke information

Coke Web Site – Coke Information

Investopedia – Video on Risk