Thoughts on the Concept of Investment Risk

January 29, 2019

“Beta is a more or less useful measure of past price fluctuations of common stocks. What bothers me is that authorities now equate the beta idea with the concept of risk. Price variability yes; risk no. Real investment risk is measured not by the percent that a stock may decline in price in relation to the general market in a given period, but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.” – Benjamin Graham

The primacy of statistical models in investment management has also led to investors to frame risk in a way that most business operators find counterintuitive. Here is one example:

Imagine you reside in Germany and decide to invest in 30-year government bond that pays an annual interest rate of 1.25%. These types of securities are often described by proponents of Modern Portfolio Theory as “risk-free” because investors are virtually guaranteed to earn the expected return if the investment is held to maturity, and the volatility of expected returns is negligible.

But consider that since 1956, the inflation rate in Germany has averaged 2.6%; and Germany is part of a monetary union where the central bank has indicated that it targets “inflation rates below, but close to, 2% over the medium term”.

Should inflation average 2% or more over the next 30 years, anyone lending to Germany at 1.25% is certain to lose purchasing power. Although the variance of expected returns for Germany’s bonds is very low, they might still prove to be a very risky investment.

In his 1952 paper, Markowitz does not provide a justification for equating risk to variance of return. This statement is assumed to be self-evident. Surprisingly, for many investment professionals, this equality has maintained its axiomatic nature to this day, despite strong philosophical and empirical objections.

It appears that the mere availability of historic variance as a descriptive statistic has overwhelmed the fact that it is a poor proxy for investment risk in practice.

How We Think About Risk

We describe risk as the possibility of not meeting our minimum acceptable return over time. In today’s interest rate environment, we consider equity returns in the low-teens as the “minimum acceptable” threshold. And more generally, we aim to grow the purchasing power of capital under our management over time.

It is important to stress that we do not expect to meet our return hurdle every month, every quarter or even every year; instead, we look at returns over a five-year time frame. We spend a lot of time explaining our investment philosophy and approach to prospective partners to ensure that we have an aligned view of an appropriate time horizon. Thus, by not using leverage and having aligned investors, we minimize the time we spend thinking about security price volatility.

Instead, we focus on factors that can cause us to miss our return hurdle. Of these, the most common are: failing to properly evaluate an enterprise’s earning power prospects; paying too much for a business; under-estimating the effect of financial leverage; and inadvertently having too much of the fund’s assets exposed to a single economic factor or technological risk.

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