Showing posts with label risk. Show all posts
Showing posts with label risk. Show all posts
Sunday, January 6, 2013
The road to long term investment success!
The road to long term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.
Friday, January 4, 2013
Investment risk resides most where it is least perceived!
“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.
I’m firmly convinced that investment risk resides most where it is least perceived, and vice versa:
• 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.
• And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. 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.
This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them. . . . Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.
“Everyone Knows,” April 26, 2007
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.
I’m firmly convinced that investment risk resides most where it is least perceived, and vice versa:
• 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.
• And, of course, as demonstrated by the experience of Nifty Fifty investors, when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky. 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.
This paradox exists because most investors think quality, as opposed to price, is the determinant of whether something’s risky. But high quality assets can be risky, and low quality assets can be safe. It’s just a matter of the price paid for them. . . . Elevated popular opinion, then, isn’t just the source of low return potential, but also of high risk.
“Everyone Knows,” April 26, 2007
Intelligently bear risk for profit!
When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.
Risk arises as investor behavior alters the market!
Risk arises as investor behavior alters the market. Investors bid up assets, accelerating into the present appreciation that otherwise would have occurred in the future, and thus lowering prospective returns. And as their psychology strengthens and they become bolder and less worried, investors cease to demand adequate risk premiums. The ultimate irony lies in the fact that the reward for taking incremental risk shrinks as more people move to take it.
To accept risk unknowingly!
The reality of risk is much less simple and straightforward than the perception. People vastly overestimate their ability to recognize risk and under-estimate what it takes to avoid it; thus, they accept risk unknowingly and in so doing contribute to its creation.
When worry is in short supply...
But only when investors are sufficiently risk-averse will markets offer adequate risk premiums. When worry is in short supply, risky borrowers and questionable schemes will have easy access to capital, and the financial system will become precarious. Too much money will chase the risky and the new, driving up asset prices and driving down prospective returns and safety.
A few risk related quotes!
My belief is that because the system is now more stable, we’ll make it less stable through more leverage, more risk taking.
MYRON SCHOLES
The received wisdom is that risk increases in the recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions.
ANDREW CROCKETT
No matter how good fundamentals may be, humans exercising their greed and propensity to err have the ability to screw things up.
MYRON SCHOLES
The received wisdom is that risk increases in the recessions and falls in booms. In contrast, it may be more helpful to think of risk as increasing during upswings, as financial imbalances build up, and materializing in recessions.
ANDREW CROCKETT
No matter how good fundamentals may be, humans exercising their greed and propensity to err have the ability to screw things up.
Failures to foresee and manage risk!
Investment risk is largely invisible before the fact except perhaps to people with unusual insight and even at er an investment has been exited. For this reason, many of the great financial disasters we’ve seen have been failures to foresee and manage risk. There are several reasons for this.
• Risk exists only in the future, and it’s impossible to know for sure what the future holds. . . . No ambiguity is evident when we view the past. Only the things that happened, happened. But that definiteness doesn’t mean the process that creates outcomes is clear-cut and dependable. Many things could have happened in each case in the past, and the fact that only one did happen understates the variability that existed.
• Decisions whether or not to bear risk are made in contemplation of normal patterns recurring, and they do most of the time. But once in a while, something very different happens. . . .Occasionally, the improbable does occur.
• Projections tend to cluster around historic norms and call for only small changes. . . . The point is, people usually expect the future to be like the past and underestimate the potential for change.
• We hear a lot about “worst-case” projections, but they often turn out not to be negative enough. I tell my father’s story of the gambler who lost regularly. One day he heard 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. Invariably things can get worse than people expect. Maybe “worst-case” means “the worst we’ve seen in the past.” But that doesn’t mean things can’t be worse in the future. In 2007, many people’s worst-case assumptions were exceeded.
• Risk shows up lumpily. If we say “2 percent of mortgages default” each year, and even if that’s true when we look at a multi-year average, an unusual spate of defaults can occur at a point in time, sinking a structured finance vehicle. It’s invariably the case that some investors especially those who employ high leverage will fail to survive at those intervals.
• People overestimate their ability to gauge risk and understand mechanisms they’ve never before seen in operation. In theory, one thing that distinguishes humans from other species is that we can figure out that something’s dangerous without experiencing it. We don’t have to burn ourselves to know we shouldn’t
sit on a hot stove. But in bullish times, people tend not to perform this function. Rather than recognize risk ahead, they tend to overestimate their ability to understand how new financial inventions will work.
• Finally and importantly, most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.
“No Different This Time,” December 17, 2007
• Risk exists only in the future, and it’s impossible to know for sure what the future holds. . . . No ambiguity is evident when we view the past. Only the things that happened, happened. But that definiteness doesn’t mean the process that creates outcomes is clear-cut and dependable. Many things could have happened in each case in the past, and the fact that only one did happen understates the variability that existed.
• Decisions whether or not to bear risk are made in contemplation of normal patterns recurring, and they do most of the time. But once in a while, something very different happens. . . .Occasionally, the improbable does occur.
• Projections tend to cluster around historic norms and call for only small changes. . . . The point is, people usually expect the future to be like the past and underestimate the potential for change.
• We hear a lot about “worst-case” projections, but they often turn out not to be negative enough. I tell my father’s story of the gambler who lost regularly. One day he heard 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. Invariably things can get worse than people expect. Maybe “worst-case” means “the worst we’ve seen in the past.” But that doesn’t mean things can’t be worse in the future. In 2007, many people’s worst-case assumptions were exceeded.
• Risk shows up lumpily. If we say “2 percent of mortgages default” each year, and even if that’s true when we look at a multi-year average, an unusual spate of defaults can occur at a point in time, sinking a structured finance vehicle. It’s invariably the case that some investors especially those who employ high leverage will fail to survive at those intervals.
• People overestimate their ability to gauge risk and understand mechanisms they’ve never before seen in operation. In theory, one thing that distinguishes humans from other species is that we can figure out that something’s dangerous without experiencing it. We don’t have to burn ourselves to know we shouldn’t
sit on a hot stove. But in bullish times, people tend not to perform this function. Rather than recognize risk ahead, they tend to overestimate their ability to understand how new financial inventions will work.
• Finally and importantly, most people view risk taking primarily as a way to make money. Bearing higher risk generally produces higher returns. The market has to set things up to look like that’ll be the case; if it didn’t, people wouldn’t make risky investments. But it can’t always work that way, or else risky investments wouldn’t be risky. And when risk bearing doesn’t work, it really doesn’t work, and people are reminded what risk’s all about.
“No Different This Time,” December 17, 2007
Many futures are possible!
For the most part, I think it’s fair to say that investment performance is what happens when a set of developments, geopolitical, macro-economic, company-level, technical and psychological collide with an extant portfolio. Many futures are possible, to paraphrase Dimson, but only one future occurs. The future you get may be beneficial to your portfolio or harmful, and that may be attributable to your foresight, prudence or luck. The performance of your portfolio under the one scenario that unfolds says nothing about how it would have fared under the many “alternative histories” that were possible.
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