My dear client – you would have by now received an email from finametrica, asking you to fill up a questionnaire for assessing your risk profile. The idea is to systematically document your appetite for risk and ensure that the investments I suggest to you are in-line not only with your financial goals but also with your emotional comfort with risk. Simply put, your scores tell me how comfortable you are with fluctuations in asset prices and how you would react when you have to take decisions under uncertainty. Of course there are technical differences between the terms risk and uncertainty, which are beautifully articulated in this link by Philippe Silber Zahn.
As the above referenced article elaborates, nearly all decision-making in our real lives happens under uncertainty. Sure we can calculate the probabilities in the throw of a dice or increase our chances of winning a Black Jack game by counting cards as Ben a brilliant student of mathematics does in this thriller of a movie 21 or even start a gambling den and make steady profits by loading the odds in our favor as all casinos do. These cases clearly fall under the category where ALL outcomes are known and risks or probabilities can be accurately calculated.
Calculating risk is valid only under controlled circumstances, wherein all outcomes are clearly known. The realm of uncertainty is different – here we operate under conditions wherein many outcomes are clearly unknown. I might dare say that life in general falls under the realm of uncertainty and for sure investing involves decision making under uncertainty. How then do the gurus of investing frame their thoughts? What makes a few investors so successful at what they do?
Benjamin Graham alluded to the concept of avoiding permanent loss of capital. When I initially came across this idea it felt obvious and trivial. After all why would any one wantonly undertake a permanent loss of capital? Over time, I realized that Graham was by no means being trivial. He was asking us to think deeply about uncertainty. Let me elaborate further. John Maynard Keynes famously said - "in the long run we are all dead". However, understanding business uncertainty over our investing time horizon is vital. Fragility of earnings, stickiness of customers, price shocks either in final product/service or input costs, aggressive competition, financial uncertainties lurking in the books such as debt covenants, low free cash flows and foreign currency exposures, regulatory uncertainty, vulnerabilities to the wrath of nature are but a few sources of uncertainity. Framing questions in terms of these factors helps to clarify the idea of permanent loss of capital. To value companies simply based upon past or even current earnings without an assessment of business uncertainty is ridden with pitfalls that can ultimately lead to a permanent loss of capital. Also to distill this idea to a price to book ratio or a price to cash ratio is being too simplistic. I know this through the hard lessons I have learnt in my investing journey.
In the long run, stock prices are no doubt a slave to earning power. However, the concept of Mr. Market swaying between euphoria and utter pessimism is a fact borne out through empirical evidence. With a keen eye on avoiding permanent loss of capital, one can embrace market price fluctuations especially in times of extreme pessimism and create massive returns on capital. The key point here is to distinguish between stock price fluctuation and underlying business uncertainty. In my opinion, no price justifies buying a vulnerable business. I have come to believe that stock price volatility and business uncertainty are two different things. Confusing the two leads to a disparity between price and value.
This brings us to your specific risk profile. Where does your risk profile fit within this discussion on risk and uncertainty? While thinking about business uncertainty is a useful tool, it is not practical to depend solely upon it to make investment decisions. The reason is that we are human and emotionally vulnerable to loss. Extreme swings in our portfolios can take place even when underlying business uncertainty does not. This places severe strains upon our ability to think rationally. A consequence is that we pull out of investments precisely when we need to stay invested and invest when we need to stay out. In light of this, it is incumbent upon an investment adviser to tailor make investment decisions to reflect the underlying levels of comfort a client has with price fluctuations. This enables clients to be emotionally comfortable with their portfolios and maintain a long-term view. My thoughts on this are that while the underlying investments can be more or less the same, their weightage must be tuned to reflect individual client comfort with price fluctuation. Thus at a portfolio level price fluctuations can be brought largely within a client’s comfort zone.