Let’s talk about risk

Risk in general

What do you imagine, when you hear the word “risk”? Not only in investing, but in general?

Risk doesn’t have an exact, “one size fit-all” definition, but we intuitively know, what risk is: when you drive a car, there is a risk you might crash, when you are a bank robber and perform your “job”, there is a risk you might get caught. Now we are starting to see some similarities- risk is an event, which negatively influences our desired outcome (for a bank robber, taking the cash home). Said simply, risk is something we don’t want to happen, but still might.

(If you know the standard theory of risk, you can skip right to the chapter “Risk in value investing”)

Numbers and probabilities

This word “might” indicates risk always has a certain probability which we might or might not now as a precise number. When you walk on the street, there is some theoretical probability that an airplane will crash directly on you and kill you, but let’s be honest, that probability is virtually zero. On the other hand, when you play Russian roulette with a 6-bullet chamber revolver, the probability you’ll shoot yourself is much higher and we know it as a precise number- it’s 16.67%.

The damage

Next, the risk also carries certain level of magnitude, so to speak. In simple words, how severe the damage will be, when the thing we don’t want to happen happens.

In the example of driving a car, let’s say the probability of hitting a bird and a deer is equal. If you hit a bird, you might get a cracked windshield and except for the poor bird, nothing too serious happens. However, if you hit a deer, chances are your car will be fatally damaged and you will most likely get seriously injured.

Okay, now that we have the basic concepts out of the way, how does risk work in the investment environment?

Risk in investing

If you open most of the investing books, you’ll see risk defined as either volatility or variance of the returns (in statistics language, volatility is the standard deviation or sigma, if you square it you get variance or sigma²). They are all basically the same thing- they tell you, how much the returns normally move around your average expected return. Let’s put it to numbers:

say you have a portfolio “A” which yields 10% a year for 30 years. That is the expected return. The important things here is the average, meaning some years it’s going to be lower, some years it will be higher making up for the losses. The volatility and thus variance of the returns in portfolio “A” is quite low- normally the returns are distributed from 9-11%.

Then you have portfolio “B”, which yields the same 10% every year for 30 years. However, the volatility and thus variance is much higher- let’s say from 5-15%. That means some years will be much worse (5%) than we expect and some much better than we expect (15%).

According to portfolio management theory, portfolio “B” is much riskier because of the higher variance. That might seem more or less intuitive to you, but my question is: why do we care about how the returns vary, if at the end we get the same 10% from both?

One of the answers is, because in the industry, portfolio managers and most funds’ performance are measured on a yearly, sometimes even quarterly basis. That means, they cannot afford to report low returns in one year, promising better results in the next one. Nobody cares- everybody wants good results now. Because of this, portfolio and fund managers will often choose investments with lower average returns, if the variance is significantly lower than in the investments with higher expected returns


Is volatility a good measure of risk?

That depends whom you ask. You have to understand, from what point of view can be risk defined as volatility. As mentioned, if you are a portfolio manager and your performance is measured every year in isolation from the others, then yes, the chance your actual return will be lower than the expected one is a risk, because it might get you fired. They also view short-term volatility in the market as risky (even when it is upward), because it creates instability and unpredictability, which investors hate.

But what if you’re not a portfolio manager chasing short-term returns, but you’re a long-term value investor, whose main concern is wealth creation across 20, 30 or even 50 years? Would you care whether you get to your goal by a straight line (low volatility) or a zig-zag line? Probably not- your main concern is so that the stack at the end is as big as possible, regardless whether you were making 10% every year, or you made 5% in one year and 15% in the next one. In value investing, risk is something completely different.


By standard measures, the red portfolio is considered riskier. But assume you have no margin requirements and both yield the same cumulative return at the end: does the volatility really matter?

Risk in value investing

I kind of hinted something about margin requirement in the plot description- since we buy only with cash, we don’t care if our portfolio value falls sharply, if we are sure it will recover. Therefore, volatility is not risk for us. So what is?

Our biggest risk as value investors is misjudging the company and its intrinsic value, leading to poor investment or even permanent loss of capital. The biggest difference is this: from the portfolio management point of view, which is focused on mostly returns themselves, their volatility is risk. However, we as value investor become company owners who participate on the underlying business, and thus the business risks become our portfolio risks.

It is the conceptual difference of portfolio management viewing stocks as a “returns vehicle” and value investing viewing stocks as parts of the company, which we are part of. Neither is correct or wrong- it is just a different approach.

Let me give you a quick metaphor. Imagine you are a restaurant or shoe shop owner, who makes solid profit every year. For some reason, your profits are lower this year, but otherwise the business hasn’t changed. You will be nervous for sure, but would you consider your business has become more risky? Probably not.

As a restaurant or a shoe shop owner, you risks are the competition in your town, risk of not getting supplies on time, poor quality of the products and so on.

Now that we know the conceptual difference, let’s take a look at some common risks we encounter as value investors.

Business risks

Business risks, as the name suggests, are risk associated with the standard day-to-day operations of the company. Normally, in the SWOT analysis, you would find them either in the “Threats” or “Weaknesses” field. The most common are:

  • Industry. The industry itself and the products provided can be considered a risk. Again, there are many reasons, but some industries might be too nascent, fast changing and unpredictable, which makes our valuation and the whole business riskier. For example, biotechnology or quantum technology companies are far more difficult to predict due to their fickle nature than Pepsi Co or Coca-Cola, since they manufacture and sell “sugary soda” as it is sometimes pejoratively said.
  • Competition. If there are too many companies, which compete with yours, there is a chance some of them will become very successful and push yours out. Also, margins tend to be thinner in competition-full segments. From the real world, beauty&cosmetics have very high competition, airplane or weapon makers have almost none
  • Regulation. There are some industries, which are more regulated by the government than others. That can stem from different reasons (key industry, controversial industry as alcohol or cigarettes, health related products as medication etc.). These regulations naturally influence and limit what the company can and cannot do, and all that can impede the success and profits of the company. (Regulation can, however, sometimes be beneficial for certain companies, when they restrict other companies to compete, creating oligopolies)
  • Country/Economy. This might not come as a surprise, but the surroundings the company finds itself in also influence it to great degree and can be considered a risk. For example, investing in companies (even the most excellent ones) in Argentina is far too risky, because the inflation is galloping, corruption is moderately high and the markets are not as developed. All this could imperil the success of the company

There is a myriad of risks we could write out and each of these branches out to “sub-risks” which stem from them.

Inherent (idiosyncratic) risks

These risks, unlike the business risks, stem from the inside of the company, but could imperil our investment as investors nonetheless. Let’s take a look at these as well.

  • Financial risks. These are the most common and could cause a lot of problems if neglected. On the other hand, they are quite fast to recognize (provided the accounting is not manipulated or fraudulent)
    • debt. A lot of debt is, surprise surprise, risky. If you have too much of it, there is a possibility you might not be able to pay it back, causing you to go bankrupt.Therefore, we try to avoid companies too much in debt
    • liquidity. Liquidity, the cousin of debt, says whether and how fast the company can pay its liabilities. It is measured in various ways, but most of the time, it is something in the sense of how much I have vs. how much I owe. If the company doesn’t have enough liquidity, it can get into problems- again, not being able to pay back its liabilities, eventually impeding its business or going bankrupt
    • profitability. This is self-explanatory I believe- if the profitability is low, the business is riskier. That is because it indicates that management allocates and uses the capital in not the most efficient way, which we don’t want to see as the owners of the capital. We want the best possible returns for our money
  • Management. This factor often gets neglected, even by hardcore value investors. We should avoid this mistake though, because management are the people, who are in charge of our money and who are responsible for growing value. Then, it makes sense to pay close attention  to agents of our money, for us as principals.
    • accounting controls. If the management, either intentionally or by incompetence, reports the financial statements in a way that does not represent the economic reality in a truthful way, it is a great risk. Put simply, if the management cannot assure the numbers we see in financial reports are correct and truthful, we cannot value the company properly
    • intentions alignment. Managements job is to grow the business, manage and allocate the capital properly and thus grow our shareholder’s value. However, not all people are moral and have crooked intentions. Sometimes, the managers just seek to exploit their power and get rich on the expense of the shareholders. We as investors must be wary of that and evaluate this risk carefully.
    • competence. Even if the managers have intentions aligned and aim to increase shareholders value, they may not be apt to do so. Put simply, they might not be so good at their job. That is of course very difficult to judge from the outside, but it is still a risk, which would cause the value to decrease, or not grow as fast.

This is just a short overview of the most common risks which I personally consider the most fundamental. Each business, however, has its specific ones which we need to recognize.

Summary (Too long; didn’t read)

In portfolio management theory, which is concentrated on returns on a yearly basis, volatility on the markets and variance of the returns is considered risk. However, for us value investors, who hold positions for years, even decades, this has little sense: we care about the final return and grow of our value, not how much it “zig-zags” along the way.

For us, risks are things, that could endanger either the company, its long-term profitability and thus our investment- competition, industry, regulation, management or poor financials. We look at these factors as business owners, because that’s exactly what we are when we invest in a company.

Do you agree or disagree? Feel free to write me your opinion and in case you have any questions, feel free to contact me at any time.

Stay vigilant.