Risking It: Thoughts on Risk and Return

Investing is about forecasting the future. The problem is… the future is uncertain. Therefore, it is reasonable to deduce that not only is risk inescapable, but it is inherently part of an investors journey. Yet most investors don’t really understand what risk is, shying away from it in ways that are detrimental to their overall journey, and in ways that aren’t really ‘safer’ at all.

Imagine you make an investment that you consider risky. You buy a stock for $100 and in a years time it’s grown to $200, a 2x return in 12 months. Now ask yourself, was it risky? It depends right. Just because the stock appreciated in value doesn’t mean it wasn’t exposed to risk. Now on the flip side, your $100 investment falls to $50, a 50% loss. Does that mean this investment was riskier than the other? Probably not. There is a difference between things happening, and things being bound to happen. 

“People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game.” — Peter Lynch

You see probable things don’t happen all the time, the same way that improbable things happen all the time. You can have the ingredients to make an informed decision – data, technology, knowledge, research – and still sustain a sizeable loss. Some things just don’t work out. Many futures are possible. Even a portfolio which has been constructed to withstand 99% of all probabilities will still succumb if the remaining 1% materializes.

In other words, returns say very little about the quality of investment decisions. Risk, which we will define as the possibility of financial loss, is necessary when understanding the quality of a decision. The problem? Future risk is immeasurable, and human beings are not good at recognising this, especially when emotions are present. Understanding risk in retrospect is interesting, but ultimately, useless.

In the good times, our brains will overestimate our ability to see risk. And in the bad times, we’ll often think the risk is worse than it is. Markets as a result swing toward or back from one extreme or the other. Participating when prices are high and shying away when there is value on the table.

Source: Fundstrat 2023

Investor sentiment in a bull market

-            The minority begin to believe things are getting better

-            More investors realize improvement is taking place

-            Everyone thinks things will be great for a long time, taking on more risk when they probably should be doing the opposite.

Investor sentiment in a bear market

-            A few investors realize the bull market is not sustainable

-            More investors realize things are deteriorating

-            The masses become convinced things can only get worse, taking on less risk when they probably should be taking on more

Recognizing and understanding risk is the first step, and human behavior remains constant over time, offering valuable lessons. The dot-com bubble burst when people thought risk had disappeared. Similar patterns emerged in 2005-2007 and again in 2021 when investors underestimated risk, leading to significant losses. Many made hefty investments in stocks at their peak, only to see them plummet in early 2022, with some wiping out gains made during the pandemic.

Renowned investors like Buffett, Marks, Munger, Druckenmiller, Miller, Robertson, and others excel not just because they generate consistent high returns, but because they steer clear of catastrophic losses. While they've experienced tough periods, their risk management strategies have kept them resilient through bad years, trades, or months.