To risk or not to risk?
To become a good investor, it is not enough to just have a good IQ. In fact, there are many examples of the greatest minds having failed in the investment game. The failure and subsequent bail-out of Long Term Capital Management (LTCM) in 1998 is one such example.
In this newsletter we explore the concept of “investment risk” and what that really means in the marketplace.
In all modern finance textbooks, risk has been defined by a number, a quantifiable figure, allowing anyone to input this into a machine to determine a possible solution. By doing this, many students of modern finance theories now believe that volatility of the financial market also equals risk. This indicator of risk, we believe, falls far short from the real truth. In general, investors do not fear volatility so much. It is permanent capital loss that investors fear.
In an industry where the search for the “holy grail” is prevalent, investors fail to realise that thinking simply and with common sense often leads to better overall long term performance. In the majority of cases, it is not the application of these highly complex formulas and models that gets them into trouble. It is usually the basic human behaviour of anchoring to past events and a lack of understanding of the risk factors (through their own fear and greed) that causes them to fail. Peter Bernstein, hailed as one of those great investing minds, wrote “we like to rely on history to justify our forecast of the long run, but history tells us over and over again that the unexpected and the unthinkable are the norm, not the anomaly”.
The devil is in the residual
When investors try to quantify risk in their modelling, the illusion of control often takes over. No model can ever have a certainty factor of 100. Financial models can statistically formulate an outcome that may have a 95% probability of achieving the desired outcome. However, it is always the 5% residual that we know nothing about that often lands investors in sorrow.
The problem is, risk only happens in the future and we are all aware that it’s impossible to know what the future holds. Statistical formula uses past events to try to determine a probable future outcome, but we also know that past events alone cannot be used to predict the future. The past seems to always be clear as only one event happened. However, when we try to work out an outcome in the future, there are various scenarios that could happen. Within these scenarios, we may also encounter variable outcomes as well. The main issue is that people usually expect the future to be like the past in their modelling, but we all underestimate the potential for change. Therefore, trying to predict the exact future scenario is nothing but a fool’s game.
What we can take from all this is that when thinking about investments, it is better to understand the approximation of the risk factors of the underlying investment than to get a “precise” figure from a statistical formula about the underlying asset. As Albert Einstein correctly observed “not everything that counts can be counted, and not everything that can be counted counts”.
In light of the heightened macro-economic and valuation uncertainty at the present time, we continue to caution you from investing too heavily at this juncture, to keep some powder dry and to be selective when investing.
Disclaimer: This publication has been compiled by Financial Decisions (AFSL/ACL Number 341678). Past performance is not a reliable indicator of future performance. Whilst every effort has been taken to ensure that the assumptions on which the outlooks given in this publication are based on reasonable data, the outlooks may be based on incorrect assumptions or may not take into account known or unknown risk and uncertainties. Material contained in this publication is an overview or summary only and it should not be considered a comprehensive statement on any matter nor relied upon as such. The information and any advice in this publication do not take into account your personal objectives, financial situation or needs. Therefore you should consider its appropriateness having regard to these factors before acting on it. While the information contained in this publication is based on information obtained from sources believed to be reliable, it has not been independently verified. To the maximum extent permitted by law: (a) no guarantee, representation or warranty is given that any information or advice in this publication is complete, accurate, up-to-date or fit for any purpose; and (b) Financial Decisions nor its employees are in any way liable to you (including for negligence) in respect of any reliance upon such information or advice.
Contact: Financial Decisions PO Box 484 Mona Vale NSW 1660, T 02 9997 4647, F 02 9997 7407