Fool's Eye View

[ February 7, 2000 ]

Risk Revisited

By Alan Oscroft (TMFAlan)

Bournemouth, Dorset -- Last week I offered a few thoughts on the subject of diversification, and it generated some good responses over on the message board. Anyone who followed it will know my thoughts on the subject; that ultimately the pursuit of diversification is the pursuit of mediocrity.

Mediocrity, of course, is far better than the achievements of those 90% or so of fund manglers who consistently underperform the index, so if we only achieve mediocrity in our investments then we should really pat ourselves on the backs for beating most of the professionals (by the way, has anyone actually ever tried patting themselves on the back? I'd pull a muscle or two before I achieved anything close, I think). So, emotive a word though it is, mediocrity ain't necessarily bad. Most Fools, though, want to do better than that.

But I haven't even started on the intended theme of today's waffle and I have already put in two paragraphs of digression, so let's get back to it. It's that hoary old topic of risk again. There have probably been more words written about risk than any other topic related to investment, plenty of which have been presented here at the Fool, a few by me even. But I make no apologies for revisiting such an old topic to offer my own developing opinions, because we must all continue to develop our own individual thoughts; if we don't, there's no point being human really.

The idea of risk is close to people's hearts, and our individual aversion (or otherwise) to risk is indeed very important in deciding the kind of investments that suit us. But in this Fool's opinion, most of the pontification that has been spouted by academics over the decades has been nothing more than hot air and would, could it have been collected, have been enough to get a balloon all the way round the world a good few years ago.

Risk is certainly the other side of the diversification coin, But what actually is it? There are probably as many answers to that as there are academics and investors combined, but opinions seem to boil down to one of two distinct camps....

• Risk is a quantifiable characteristic of an overall investment portfolio that can be stated in numerical terms and minimised arithmetically by applying academic theories such as modern portfolio theory, and derived ratios like a share price's beta , while attempting to achieve a stated target for returns.
• Risk is an inherently unquantifiable aspect of any human endeavour, and no two endeavours are ever the same. Theories derived from portfolio-based generalisations, or from past share price movements, tell us absolutely nothing about the real level of risk associated with the prospects for an individual company's success.

It is probably pretty obvious which camp I am in myself, and I think ideas of the ilk of the first camp are bunk. They are interesting bunk, academically fascinating bunk sometimes, but bunk nonetheless. In practice, I think such theories are pointless in that they provide no practical approaches to improving the quality of our individual investments. And that, surely, is the only way to minimise real risk.

And real risk? An idea of that can only be gained through experience, through thorough understanding of the companies that we are investing in and their industries, and through a strict and unemotional approach to developing our individual company selection strategies.

There are many people out there (including some who have done and will continue to do well, no doubt) who have made a high-risk investment or two and then decided to compensate for that by making a couple of low-risk investments. You might, for example, buy some shares in ARM Holdings (LSE: ARM) and then decide that, because it is a high risk investment, you'll buy some BP Amoco (LSE: BPA) too, to balance. BP is, after all, the second-largest FTSE 100 company, and is in a completely different industry. By isn't that defeating the whole point of buying ARM in the first place?

My view is that such a strategy contains one of two possible flaws; either that you have not been able to get a good enough feel for the risk of investing in ARM and are uncertain as to whether it exceeds the level of risk that you are happy with, or that you know deep down that the risk associated with an investment in ARM is really too rich for your blood, and you need to dilute it with something of much lower than your average risk, something that you would not have otherwise bought.

If either case applies to you, then I would argue that you should perhaps not have invested in ARM in the first place. Instead, you might have been better off seeking individual investments more closely associated with your acceptable level of risk and which you understand well. Better to have two investments that you are confident of and that have individual levels of risk that you are happy with, because that implies that you have analysed and understood your investments better, than one that is too risky and one that is just a safeguard (and which you would not otherwise have chosen.)

So, to summarise. Here, I think, are my core thoughts on portfolios and risk....

• There is no such entity as a portfolio, only individual investments, and there is no connection whatsoever between any individual investment and any other.
• If we think of our collection of investments as a portfolio in terms of applying portfolio-based theories to it, we will achieve a whole that is less than the sum of the parts.
• Risk, therefore, should be seen as being associated only with individual investments, not with an overall portfolio.
• Treating each individual investment only on its own merits will improve our analytical skills over the long term.

Many will think I am the one talking bunk today. If so, please debunk away on the Fool's Eye View message board.


Related Links
• Fool's Eye View -- Diversification
• Fool's Eye View message board