Fool's Eye View

[ November 20, 2000 ]

More Risk

By Stephen Bland (TMFPyad)

Following on from an article I wrote a couple of weeks ago in my value series, I would like to say a little more on risk in general, because of course all equity investors face risk. But it is the risk-adjusted return with which I am concerned here.

Suppose you give an equal sum of money to two people to invest for you. You do not know anything about their methods but later on each gives you back your money plus the same percentage, so the arithmetical return is identical. On the face of it their investment performance is the same.

Now take it further and imagine that one had invested in an entirely safe area, say gilts to maturity (and they don't come any safer from the point of view of the likelihood of default) and the other had been betting in a casino and struck lucky, clearly one of the riskiest ways possible to "invest" money. These two approaches are at entirely opposite ends of the risk spectrum. Yet the monetary returns are the same. So what is going on here?

Before you knew how these two invested for you, there was no way of judging their quality against each other because both produced the same return. Superficially they appear to be equally good investors. Once you know though, you would almost certainly come to the conclusion that the gilts player was somewhat more reliable, just a little less risky than the blackjack player. So in future most rational investors would entrust their money to the gilts person, rather than the gambler, even if the latter claimed to have a system, because the gilts man is much more likely to be able to repeat his performance. Repetition is the test of anybody claiming to have a winning investment strategy.

But my point is that you can do this only by applying a risk test to the two different investors. Until you know how they make their money and then try and quantify the risk factors, you have no way of knowing and could be forgiven for assuming that their qualities were very similar.

This is not only some vague theory. Share or fund investors will often fail to take this into account. If you buy a share and it doubles, is that the same kind of investment as someone who does the same trick with a different share? Probably not, if the risks were not similar. Making a 100% gain in a blue chip is very likely a less risky achievement than doing so in a small biotech for example. In fact you would have to make a far bigger gain in the small cap in order that the returns were similar on a risk-adjusted basis.

The general investment proposition is that one wants maximum reward for minimum risk. Take money on deposit. Ignoring disasters like the bank going broke, the risk is zero. You can't lose, only win. But all you can ever win is the prevailing interest rate. You can't expect more for taking zero risk. Once you get into equities, because you want to try and generate a higher return than cash, then you must accept risk. But not all shares carry the same degree of risk, although it is not necessarily that clear just how much risk is attached to any particular one compared with another.

I have noticed on some website that a new risk measurement service has been introduced that gives you a numerical figure that is supposed to indicate the risk of individual shares. I think it is derived from historical volatility patterns, something similar to "beta" though a little more complex than that. Beta is the historical volatility of a share relative to a market index over a given period. A beta of one over a period tells you that the share moved by the same percentage as the market. A beta of minus one tells you that the share moved by the same percentage as the index but in the opposite direction, and so on.

The obvious possible flaw in all this is that it is historical and it does not follow that the same pattern can be relied upon to repeat in future. All it tells you is how risky the share was in the past, in the sense that volatility is risk. I have no experience of the worth of this system but it is perhaps an interesting development if it proves to be reliable to any exploitable extent.

What I am advocating, then, for equity investors, is that when you consider a share purchase, ask yourself how risky that share might be. With value investing we try to cut down on the downside risk by insisting on cheap fundamentals like low P/E and low price to book value. Then if something goes wrong, the share is likely to fall far less than one that is already highly rated. The value player's idea of financial heaven is the share with very low downside compared with high potential upside. This classic value situation takes out as much risk as possible with a share whilst presenting substantial potential profit.

But the concept of giving some thought to risk does not apply only to the value strategy, which is why I am writing about it here. Suppose you like to play biotechs. Many investors would find all these shares high risk and there have been some spectacular recent collapses. I don't follow them but it occurs to me that if I did, then despite the characteristic that they are probably all higher risk than most shares, some would prove to be more risky than others. I would therefore try to find a way of ranking the relative risks of the shares in the sector.

Common sense, for example, suggests that a company pinning all its hopes on one thing is a riskier bet than one with a stable of products, even if in both cases they are still at the development stage. Anything to try and minimise the downside of what is a very high-risk type of business in the first place. You could probably never minimise it like a value share, but you could minimise it by the standards of the kind of risk that attaches to biotechs.

Having ranked all the shares in order of how I perceived their risk, only then would I start looking at upside potential. The shares to choose then would be those combining the lowest risks with the maximum upside. The market being what it is -- that is, not entirely rational -- it may well transpire that some anomalies are revealed by this kind of analysis that present money making opportunities combined with a lower risk than that presented by biotechs in general. That is the combination to seek. In doing this you improve your chances of winning by lowering your chances of losing. Cutting out losers is a great way to make money.

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