The Tricky Business of Risk

Over the years, we’ve had many conversations with our members and their advisors on risk. While Princip.al does not provide any investment advice, mainly acting as an information channel to and between family offices and other investors, it’s essential for us that we understand what risk truly is.

One of the most common misconceptions, often pointed out by our members who are less public market prone, is that volatility is risk. The stock market is a good example of this. For instance, the Nintendo company’s stock market value suddenly rose massively through the success of the Pokémon Go game, then to suddenly drop again when Nintendo kindly pointed out they wouldn’t make too much money out of it.  That’s volatility to you.  Was the Nintendo company riskier or less risky before or after the announcement? Probably not.  It’s the same company with the same management making the same products in the same countries and currencies.

It of course depends on how you define risk.

If you’re a fund manager who gets rewarded or dismissed based on continuous short term results, then doing worse than the market is your main risk, and downward volatility (prices going down) is your main risk.

If however your job as an investor is to invest for the long term, then risk is more the permanent loss of value and capital. So for instance, if you’re an investor in a shipping company, your main risks are political (a war breaks out and submarines start sinking your ships – permanent loss of capital and human lives) or business is that bad that you can’t pay your creditors anymore and you go bankrupt (permanent loss of capital). For an investor in agricultural land, having your land confiscated, climate change turning your land into desert or a bad crop preventing you from paying the bank back are the real risks. To investors with a long term view, quarterly results and stock market gyrations are indicators of risk, but not risk itself.

So how do long term investors manage their risk?

In this case, I’d prefer not to dwell on currency, political and fiscal risks which all can be managed to an extent as well, instead focusing on some rules of thumb that seem to hold true in all currencies and jurisdictions.

Diversification is one of the most obvious answers. A wise man knows the limits of what he knows. Diversifying is one of the few ways in which to protect against what you don’t know, as you can’t know. You can off course diversify that much that you’re in businesses or countries which you don’t understand. But as you can already diversify amongst 10 or 20 holdings, that shouldn’t be a problem. If not, there’s a whole asset and investment management industry out there to help you invest in sectors you’re less familiar with. Whatever the problems of diversification are, they do not weigh up against the risks of having all your wealth into only one asset.

Another risk mitigator is low leverage. Long term investors generally will put the bulk of their assets in businesses and assets that are conservatively leveraged, if at all. Cycles come and go and accidents may happen… Cash at hand and few or no debts make for an easy conversation with the banks when times get rough.  Or as a friend of mine puts it: “Problems are so much easier to handle when you can throw cash at them”. It sounds foolish, it’s not. Handling problems without cash at hand is a lot riskier.

Dividends are also a good risk mitigator. Not only do dividends flow cash back to you, they also make a company think harder before expanding or engaging in mergers and acquisitions (and studies indicate M&A are a perfect source for capital destruction).  Off course, do not get blinded by dividends. If a company needs to borrow or sell assets to pay dividends, that’s just window dressing. True dividends come through reliable cash flow.

Finally, a word on price. What you pay for an asset also makes it more or less risky for you. When you buy a good asset, say good agricultural land, at such a high value that no fool will ever buy it from you at that price some years down the road, you will have permanently lost capital. That’s risk.

An innocent bystander looking at Bunds and T-Bonds in 2016 may also think about risk. Buying a good asset cheaply is one of the best ways to protect against risk as you’ve made a buffer against partial capital loss in the future. That doesn’t mean it’s foolish to pay a full price for quality assets as great businesses or assets only very rarely come dirt cheap. It’s a bit like ordering at a restaurant. Overpaying for an average or bad meal is bound to ruin your day. You’re better off paying full value for a dish you know you’ll enjoy in a place you trust. Off course, if you can have a superb meal for next to nothing,  it’s joy to the world. But how often does that happen to you? When it does however, make sure you’ve got plenty of cash. And plenty of appetite.